The manager of the £53.6m WDB Oriel UK fund says a rise in interest rates will hit equities, particularly growth stocks, apart from commercial banks who will benefit from more expensive lending.
“Long duration stocks are hugely threatened by rising interest rates,” he said. “If you can find businesses that are un-threatened by rising long term interest rates you should be giving them serious consideration.”
“We realised at the beginning of the year that there was a potential vulnerability in the portfolio which was starting to feel uncomfortable.”
“So we started looking for companies that would be neutral or even beneficiaries of the rising interest rate environment. That doesn't lead you to many places other than deposit-long [have more deposits than rate-sensitive liabilities] commercial banking franchises.”
However, Barton says he has been unable to find a UK commercial bank that doesn’t have other challenges that outweighs its benefits. This led him to take a position in the US Bank Wells Fargo in the past few months.
“We have held HSBC but our recent moves into banks have all been outside the UK,” he said. “In theory there is a play in the UK commercial banking space although there is only one name: Lloyds bank.”
“However, I have reservations about using Lloyds. Rising interest rates will also mean bad debts go up which seems to me to be a material risk in a housing market that hasn't been sorted out in the UK.”
“Lloyds could see the benefits of a better deposit franchise from rising earnings but this would be offset by escalating bad debts, particularly on its mortgage book, as they are not carrying enough capital.”
Performance of banks over 1yr
Source: FE Analytics
He says a rise in the cost of capital from an interest rate hike also has the ability to swamp the pick-up in the rate of economic growth.
“I am very, very conscious of broad factor risks within portfolios and the biggest risk facing equities is the future direction of long term interest rates if you have a quality bias in your portfolio.”
“At the beginning of the year you'd have thought that long term interest rates could only go up but they have actually recently come down across the board.”
“There is undoubtedly a shortage of opportunities out there. Between 2009-11 there were a lot of very good companies at prices that nowhere near reflected their long term economics.”
“For those of us who invested in higher quality businesses in the last 4 years we have had a phenomenal re-rating.”
“I'd love to say there are a lot of opportunities to repeat this in today's market but if there are I can't find them. Either you compromise how you invest or sit quietly for a while.”
Barton took over the WDB Oriel UK fund in January 2009, since which it has returned 41.16 per cent beating both its sector and benchmark, over the same period.
Performance of fund sector and benchmark over 3 yrs
Source: FE Analytics
However, over the past year it has fallen below the average return in the sector but stayed ahead of its benchmark.
Performance of fund sector and benchmark over 1 yrs
Source: FE Analytics
Despite his interest rate worry, Barton says fund managers worry too much about macro headwinds.
“Fund managers think too thematically about their investment process. They can think too much about the macro side.”
“We don't think about indices or benchmarks and we try to be as indifferent to macro as we can but you have to have a broad view of what is going on in the world.”
“Part of the problem being driven by macro is that you get your timing all wrong. You tend to be overexcited at the top and panicking at the bottom which is the wrong way around.”
The WDB Oriel UK fund is highly concentrated with just 25 holdings and a low turnover rate of about 10 per cent.
Barton says he tries to keep each holding at about four per cent of the portfolio and hold each stock for more than five years.
This style coupled with a dearth of opportunity in the market place has led him to steadily increase his cash holding to 6 per cent over the past twelve months.
“We don't explicitly build cash to a certain level to try and take advantage of market corrections it is just a function of opportunities and threats.”
“An individual stock may have got too big or has gone too far so we take profits but if there isn't anything that looks attractive we will hold cash.”
“In the current environment that is a dangerous game, because it means negative returns after costs. However, that is better than buying a stock that is not appropriate.”