What is in a name? Well, for financial products, quite a lot, actually. Under the FCA’s conduct of business rules, investment product names cannot be misleading about the nature of the investment. So the Revera UK Dynamic Fund was deliberately named and – we hope – clearly presented as such when we have discussed the fund with investors and advisers. The key adjective here being “Dynamic”. The use of that word was deliberate, to emphasise the fact that its nature would change with differing investment circumstances that it faced. That, in order to deliver two tenets of our corporate strategy – “looking after your wealth for the long term”, and “looking after your wealth as if it were our own” – we would be flexible and responsive to changing economic and investment conditions.
Looking at the history of the fund, it is fair to report that radical shifts in investment strategy have not been a particular feature of its past performance. The fund was launched in the depths of the financial crisis, and since that time we have typically employed a “risk-on” strategy, buying undervalued businesses that would benefit from the gradual rehabilitation of the global economy, and in recent years with a particular bias to UK domestic activity. In our opinion, that strategy has been successful. The fund has more than doubled in share price terms over the last five years, and the current share price is more than three times the value it reached at the nadir of the financial crisis. Compared to the peer group, we sit in the upper half of the top quartile of peer group performance over three and five years *.
However, we have also said that we view investment with an absolute return mentality. We would not for one second promote our funds as absolute return, but we view every investment we make in terms of how much money we can make from it, and what risk we are taking to get access to that potential upside. We do not view risk as a deviation from a benchmark. We view risk in terms of corporate strategy, financing and cash flows, industry dynamics, earnings security, valuation and liquidity. We also have a disciplined framework for assessing these risks. We call upon the knowledge and experience of two retained consultants – Adrian Cunningham and Bob Semple – to help us analyse the global and UK macroeconomic environment, the issues affecting other risk markets, and technical drivers of the UK equity market. We also counter balance this with the emotionally detached “Traffic Light” framework, that helps us objectively view the risks we are taking to achieve upside in equity investment.
With our latest strategy meeting taking place at the start of the month, we have concluded that the risk environment has changed. The UK Dynamic Fund will have to live up to its name, and materially change the nature of the risks it is taking. There are four broad (but interlinked) risks that we feel have risen to a level where action on the portfolio is merited. The first is in relation to earnings revisions. We have highlighted over the last year how persistent the decline in earnings expectations for the market had been, and felt that the equity market could only go so far without a reversal of this trend. After some flickering signs of recovery earlier in the summer, recent data have been firmly and broadly weaker. At the same time, however, the valuation risk on the market has increased. The UK market’s trailing PE is higher than at any time since the absolute depths of the recession, without the corresponding expectation of a snap back from cyclically low profits. This UK equity market concern is being played out against a backdrop of recklessness in credit markets. Our review of credit markets suggests that in the hunt for yield, buyers of new credit issues are foregoing the traditional protections (covenants) that one looks for in corporate bonds, and that high yield risk is inappropriately priced. On top of all of this, the Chinese economy is sending out worrying signals over property market bubbles and industrial production.
One can rightly point out that these issues have been building for some time – why act now? Because we see the prospects for rate rises in the US and UK as inevitable over the coming months. We are convinced that the Federal Reserve in particular wants to see a more appropriate pricing of risk in financial markets, that Dr Yellen’s variant of the “Greenspan Put” is being put away for the remainder of this cycle. Whilst consensus is becoming very tight around the timing of the first US rate rise, history tells us that only when the deed is done will we see what the ramifications of tightening monetary policy are going to be. What we do know is that it will put pressure on valuations in both credit and equity markets, and it will raise questions over the future trajectory of economic growth. Neither of those features will be pleasant in the short term.
To be clear, we are not calling the top of this cycle – neither in terms of stock markets, nor economic growth. What we are saying is that a re-calibration of risk and reward is required. To that end, we will bank a portion of the significant profits generated in the last five years. We will look to reduce certain risks in the portfolio – most significantly valuation risk and liquidity risk. Above all, we will look to maintain substantial levels of firepower and patience to capitalise on opportunities that we are certain will emerge in the coming months.
We equally need to be clear that we are not changing the way we go about our business. The Revera “DNA” remains intact – we run focused and evenly weighted portfolios of companies that are established, profitable and generate cash. These investments will all be appropriately valued for the underlying risk involved in generating those profits and cash. But where the key driver of investment return in the last five years has been to have the right businesses to exploit a cyclical recovery, more of the portfolio in the short term is likely to be in businesses where self help and industry trends play a bigger part in the generation of returns.
We can’t (and wouldn’t even if we could) go into the exact nuts and bolts of the changes we anticipate in advance of effecting them. However, we referenced earlier two tenets of our corporate strategy. One of the others is “to give you the information you need” to make informed decisions on your investment. At this point, we can be clear that the Revera UK Dynamic Fund intends to live up to its name.
*Data correct as at 31st July 2015. Source: Revera