UKFeb 8 2017

R&M: Cyclicals can sustain pickup

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R&M: Cyclicals can sustain pickup
Fund performance vs IA UK All Companies

Cyclical stocks can extend the rally that ignited towards the end of last year into 2017 and beyond, the managers of the River & Mercantile UK Long Term Recovery fund have predicted.

William Lough, who works on the £111m fund with Hugh Sergeant, noted that the team – which shifted away from domestic plays such as Greggs in late 2015 in favour of globally oriented names – would maintain “big sector overweights” to banks, oil and mining firms despite their significant recent gains.

Mr Lough believes momentum can persist for selected companies following a rally in the final months of 2016.

“What encourages us in terms of the outlook is that, despite strong recent performance, the overall valuation metrics are still attractive in absolute and relative terms,” he explained.

“Price to book of 1.3 times is 30 per cent cheaper than the index, while earnings and cashflow yields are both similar to the market average despite above average recovery potential from depressed levels of profitability within our portfolio companies.”

As such, the fund holds “key overweights” in banks such as Lloyds and RBS, which sit alongside positions in HSBC and overseas names including Citigroup, Mediobanca, and Japan’s Sumitomo Mitsui and Mitsubishi UFJ.

“The banking sector has clearly been a bit of a whipping boy for investors, not just across the UK but all markets,” said Mr Lough. “The effects of creeping regulation and people thinking that low interest rates are going to last forever and banks will never make a profit were pretty ingrained in investor psychology. 

“We think names such as Lloyds will reap the fruits of retrenching the business into areas where they had a competitive advantage, as there’s a profound shift in the market.”

In oil and gas, the team favours mega caps such as BP and Shell, as well as “well-funded” oil exploration stocks with producing assets, including Faroe Petroleum and Amerisur Resources.

Miners such as Anglo American represent a third significant chunk of the portfolio.

“Last year Anglo put in a huge self-help programme,” said Mr Lough. “Returns should be turning around. It is also one of the few mining companies where the commodity deck hasn’t already rallied. It has exposure to coal but has a greater proportion in things like platinum and diamonds. Anglo shrank the business but higher commodity prices mean it does not have to be a forced seller. It might have been a fire sale and, as shareholders, we would have got a raw deal.”

The team is also hoping for alpha from other industries, often where events such as a change in leadership can trigger improvement at a business. Examples include De La Rue, which prints banknotes, and software and professional services company SDL, both of which have recently come under new management.

“De La Rue is more than 300 years old,” Mr Lough said. “The perception is structural decline. The previous management, in our eyes, didn’t seek to change that proactively enough. 

“But a new chief executive has come in and challenged existing practice and has a big focus on return on capital. 

“Once we strip out the structural headwinds for the business, there are some interesting elements. Polymer has a 5 to 10 per cent share of the market and could grow. Also, most governments now want to dual source [and could use De La Rue].”

The UK Long Term Recovery fund sits in the first quartile of its IA UK All Companies peer group on both a one- and five-year basis, according to FE Analytics. Over three years it has performed less well, returning 20.7 per cent compared with a 20.3 per cent average from the peer group.

 

Sector weightings

SectorWeight in fund on December 31 2016 (%)
Oil and gas13.4
Basic materials11.5
Industrials14.4
Consumer goods6.8
Healthcare5.4
Consumer services10.2
Telecomms3.5
Utilities1
Financials27.4
Technology6.5

 

Source: River & Mercantile