Q&A: Marlborough Multi Cap Income investment update

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“It won’t be a straight-line recovery, of course, but we believe the stage may now be set for a change in fortune for some stocks that have been very much out of favour.”

Siddarth Chand Lall

Marlborough Multi Cap Income Fund Manager Siddarth Chand Lall says more and more companies are reinstating dividends and if banks follow suit the ripple effect could be felt across a range of other sectors.

It’s been a difficult year for UK equity income. How would you characterise the investment landscape at the moment?

“In my previous reports I’ve referred to the ‘ABC’ of risks, which are now developing into positive stock market catalysts. That’s the American election, the Brexit trade deal and progress with COVID-19 vaccines. With Joe Biden now President-elect and better than expected trial results for the Pfizer/BioNTech and Moderna vaccines, two of those risks have reduced significantly. This is good news not just for global markets but the UK equity income sector in particular. I will explain the A-B-C points individually.

“While we still have the prospect of legal challenges from the Trump team, it seems reasonable to expect a more stable administration under Biden. If the new government adopts a moderate foreign policy it is likely to include a more conciliatory approach to trade with China. This would be a decisive step away from protectionism, positive for the global economy and good for many of our UK companies, who also have operations abroad.

“On Brexit, our expectation is that a ‘win-win’ trade deal will be negotiated providing a clear framework for businesses to operate under. The recent changes in Boris Johnson’s government are helpful to achieving a breakthrough in negotiations with the EU. The alternative is to shift to World Trade Organisation (WTO) terms in 2021. Either way, once the uncertainty is removed, attention will shift back to company fundamentals and what the correct intrinsic value of these businesses should be. In our view, that value has been considerably underestimated for many UK companies since 2016.

“The best news from a sentiment perspective is the vaccine progress. We have been saying for some time now that there will be more than one effective vaccine. Each will have its pros and cons and there may be logistical issues early on, but that is a nicer problem to have than worrying about whether or not the medical science works. Hopes for a permanent lifting of lockdown measures and business activity resuming to more normal patterns are now founded upon genuine substance.”

Company dividend cuts earlier this year received a huge amount of attention. What is the current position with dividends?

“The picture has steadily improved throughout the second half of the year and even now we continue to hear of companies reinstating dividends. Not just that, many have paid an ‘additional interim’ dividend to make up for previously skipped payments. While some like Telecom Plus are maintaining dividends year on year, others like Intermediate Capital are growing them. Some are even announcing special dividends, including 888.com, Admiral, B&M European Value Retail and Direct Line Group.

“In our fund we currently hold 113 companies, of which only 17 are yet to restart paying dividends. That’s 12.5% of our companies by invested portfolio weighting (excluding cash) and the picture is improving all the time.

“Looking at the prospects for dividends more broadly, I think what’s happening in the banking sector, a sector in which we are currently underweight, is hugely important for what could happen to the wider market in nine to 12 months from now. In March, the Bank of England asked banks to halt dividends, so they would have additional cash on the balance sheet to act as a cushion against potential bad debts caused by the pandemic. The scenario they had been asked to imagine was the following: high levels of loan impairment for an indefinite period of time. This quite rightly did not leave much room for shareholder distributions.

“As it happens, before the news of any vaccine, the better banks managed market guidance rather well. They were prudent about what levels of impairments should be factored into analyst models. Evidence from the most recent quarterly reports reveals that the magnitude of loan defaults has not been anywhere near as bad as it could have been. We agree with the SecretaryGeneral of the Basel Committee on Banking Supervision, Carolyn Rogers, on it being too early to take a ‘victory lap’. However, so far, profits have been better than expected, cashflow forecasts are stronger and banks are seeing their balance sheets improve again. For example, if we look at Barclays, which is a bank we do hold, their loan losses in the third quarter of 2020 were 40% below consensus expectations. Analysts at Berenberg believe estimates for overall bad debt losses for Barclays may still be 30% too high. In contrast to the last crisis of 2008, this time banks have played their part in supporting the broader economy with loans to businesses continuing. Carolyn Rogers acknowledges this and despite this lending, the surplus capital on bank balance sheets has increased (Barclays posted a record CET1 capital ratio of 14.6% in Q3 2020). Even the more neutral analysts are starting to factor in a final dividend for Barclays (Investec, 10th November). It is worth remembering the function of a dividend before demonising it. Not only does it maintain a cashflow discipline for the banks, it also avoids them lending imprudently. At some stage, with an increased capital base, if they don’t start paying dividends again this will result in inferior Return on Capital Employed metrics versus their global peers.

“In light of progress with COVID vaccines, and what that means for economies around the world, we believe that the scale of likely bad debts has diminished considerably for not just Barclays but the banking sector as a whole. Sure, there may be aftereffects of rising unemployment and slowing economic growth in some regions but it is certainly not going to be for an indefinite period of time anymore. Given other banks are also building up cash reserves appropriately, they too can afford to restart dividends in 2021. Whether the Bank of England wishes to listen only to the Basel Committee or use its own judgment is another matter. We would like to see a rational regulator which does not apply a ‘blanket’ ban but rather makes allowance for the better banks with strong balance sheets to be treated differently to the ones that have been less prudent. We have already seen this in the European insurance sector for instance, where the likes of Chesnara and NN Group have paid dividends as promised, having previously experienced a similar check from their respective regulators.

“It may take a number of months for such changes to come through but the ripple effect will be felt way beyond the banking sector. Financial markets are built on confidence and the banks traditionally lead this confidence. What is notable this time is that the wider equity income sector has already moved positively having been severely oversold. But when the banks do reinstate dividends it will spark another look at the second and third liners as valuations are totally out of sync. The housebuilders could quite possibly be next to reinstate dividends, for instance, although even here, a few have already confirmed them for 2021. The stock market is supposed to price in future events six months in advance or at least partially price them in. So, one might argue the recent rallies we have seen are just the beginning.”

How have the companies in your portfolio performed during the crisis?

“While sectors such as hospitality and travel have really struggled, there have been other business areas where companies have continued to perform strongly.

“Home entertainment is one theme that’s emerged as a winner. With lockdown and working from home requirements, people have returned to reading more and in different formats. Bloomsbury Publishing has reaped the benefits across its print, e-book and audiobook offerings.

Bloomsbury is probably best known as the publisher of the Harry Potter books, but there’s a lot more to the company than that. It is a global business, with 67% of its revenues coming from non-UK markets. Profits before tax were up 60% in the six months to the end of August, the strongest first-half performance since 2008.

“Online shopping has been another growth area and the Supermarket Income Real Estate Investment Trust (REIT) has been well positioned to benefit. The REIT invests in highquality supermarket properties that it leases to companies including Tesco, Sainsbury’s and Morrisons and it favours omnichannel sites that combine traditional stores and online fulfilment centres. The REIT achieved an 11.6% total return for shareholders over the year to 30th June 2020 from which it can afford to distribute a high yield of 5.5%.

“Another effect of the pandemic has been a surge in pet ownership, as people turn to animals to combat lockdown loneliness. The Kennel Club reported a 168% increase in enquiries from people wanting to buy puppies during the first lockdown, compared with the same period last year. Pet supplies retailer Pets at Home has benefited from increased pet ownership and has adapted its business model, boosting its online proposition with a new 60-minute click-and-collect service. It’s a strong business in a high growth area. Pet owners will still need to provide food and medicines for their animals once we emerge from the pandemic, so we believe the future is positive. In September, the company announced that it expected interim profits to be ahead of market expectations.

“Finally, I’d highlight Polar Capital as an example of a stock we hold (and have done since launch) where we believe there’s still a lot of upside potential. With the UK stock market out of favour, investors may have been deterred from what they perceive to be a UK asset manager. In reality though Polar Capital has a major international focus, with around 70% of its assets under management invested in global healthcare and technology funds. It’s on a forecast P/E of 12x for 2021 and is yielding 5.7%, so we think it is cheap.”

How would you characterise the investment outlook?

“We’re fairly bullish on the outlook for UK equities. With two major global risks developing into positive catalysts and greater clarity on the Brexit trade position looking imminent, it does feel like progress. It’s reminiscent of when the then Federal Reserve Chairman, Ben Bernanke, announced the first wave of quantitative easing in 2009. Markets didn’t recover immediately, and for a long time investors were coy about calling a bull market or recovery even though all the while it had already started.

“It won’t be a straight-line recovery, of course, but we believe the stage may now be set for a change in fortune for some stocks that have been very much out of favour. Company earnings must continue their recovery first and then price-to-earnings multiples can be reassessed upwards to get a double whammy.

“We remain vigilant about what the banks say next and there will no doubt be bumps in the road, but overall we believe the outlook is looking increasingly positive.”

Siddarth Chand Lall 19/11/20

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Capital is at risk. The following is a summary only of some key items in the Prospectus and more details can be found in the Prospectuses. Investors in Protected Cell Company (PCC) must have the financial expertise and willingness to accept the risks inherent in this investment. Past performance is not a reliable indicator of current or future performance; it may not be repeated and should not be the sole factor considered when selecting funds. It should be appreciated that the value of Shares is not guaranteed and may go down as well as up and that investors may not receive, on redemption of their Shares, the amount that they originally invested.
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