Higher-than-expected bond yields and interest rate hikes are the biggest factor risks for quality growth investors right now, according to CRUX’s Patrick Barton and Jamie Ward, who are unconvinced that the recent pullback in the value/growth rotation will prevail over the medium term.
As such, the managers of CFIC CRUX UK are using their ability to hold up to 15 per cent in overseas equities to allocate to US banks, which they say offer attractive bottom-up fundamentals as well as some protection against rate rises.
When it comes to positioning for upcoming macro events such as the snap general election though, they are planning to remain steadfast and maintain their long-term term investment approach.
“Ultimately, the risk to us is that bond rates and interest rates rise ahead of where market participants think they’re going to go,” Ward said.
“In that case a lot of longer-duration equities, and in fact most equities in general, would seem vulnerable.
“Although we find value and quality in banks, we also get a nice balance alongside the longer-duration stocks in the portfolio.”
CFIC CRUX UK aims to preserve and enhance the real value of capital allocated to the fund, as well as to comfortably outperform its FTSE All Share benchmark.
Over the last five years, for instance (the fund was formerly known as CFIC Oriel UK before the firm was acquired by CRUX), it has outperformed its benchmark by 15.49 percentage points with a total return of 76.14 per cent. It has achieved this with a higher Sharpe ratio (which measures risk-adjusted returns) than its average peer as well as a top-quartile downside risk ratio (which predicts a fund’s susceptibility to lose money during falling markets).
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
It aims to meet its goals through a highly-concentrated portfolio of predominantly large-cap stocks, which the managers believe to be high-quality cash compounders that offer high returns on capital. The fund’s largest holdings include the likes of HSBC, advertising giant WPP and, unusually for an IA UK All Companies constituent, JPMorgan Chase & Co.
“Our view is that US banks were cleaned up post the financial crisis in a way that did not happen in Europe and, to some degree, in the UK,” Barton explained.
“The second point would be that we see less vulnerability to significantly increased loan losses in US lending compared to UK lending, particularly the UK in that instance because the US consumer has deleveraged to a much greater extent than the UK consumer.
“The most important thing about the US banks is that they have proper deposit franchises, which is to say they are predominantly convenience-sensitive deposits and not rate-sensitive deposits. That is to say that US loan books tend to be substantially smaller than their deposit books.”
When it comes to banks generally, the managers point out that, unlike industrial businesses, the valuation is derived largely from its liabilities and how they control their cost of funding as opposed to how they use it.
“Although are very excited about the standalone investment opportunities provided by banks, as a whole, the presence of a significant weighting to banks within the portfolio solves a factor risk which we have been particularly concerned about over the last two or three years,” Barton continued. “This is the potential impact of a rising rate environment on equities generally and particularly longer duration equities, which is where the bulk of our portfolio is positioned.
“If you are in the quality space, you will tend to be longer duration in the nature of the types of things you will end up with.
“We were very keen to mitigate that major factor risk. During the second half of last year when people started to buy into the reflation trade and people started to realise that interest rates didn’t stay at zero forever, it was the banks that protected us.”
Throughout the course of 2016, CFIC CRUX UK returned 18.74 per cent compared to its sector average’s return of 10.82 per cent and the FTSE All Share’s return of 16.75 per cent.
Performance of fund vs sector and benchmark in 2016
Source: FE Analytics
While the managers are of course pleased with this performance, they are keen to emphasise that they select stocks with a long-term time horizon and do not make short-term macro calls.
“There’s a good reason we’re not speculators because, even if we knew what was going to happen months beforehand, we probably still wouldn’t have positioned correctly for it,” Ward said.
“We simply said that we didn’t know which events would occur and we did quite well, because we were in good stocks and because we had addressed a factor risk. We were not anticipating in the second half of the year that the US banks would do as well as they did, but they did because that was the environment.
“I think that’s risk management rather than brilliant stock selection to navigate a short period of time.”
The violent growth/value rotation during the second half of last year took many investors by surprise, with only 45 out of 260 funds in the IA UK All Companies sector outperforming the FTSE All Share benchmark.
While Barton and Ward used this opportunity to add to some high-quality positions in the portfolio, they are nevertheless surprised at the pullback in the growth/value trade this year. In 2017 to-date, the FTSE World Growth index has comfortably tripled the return of the FTSE World Value index with a return of 7.21 per cent.
Performance of indices in 2017
Source: FE Analytics
“I think what we saw at the tail end of last year was that people were not distinguishing between the deflation trade, the bond proxies and the more highly-rated businesses that still had a degree of economic sensitivity and would therefore, in a better economic environment, see their revenue profile improve a bit further,” Barton explained.
“This year, that reflation trade has run into the sand a little bit – people have become nervous about it. The miners ran in January and then have tracked all the way back again, the banks had a poor January, a good February and then have tracked back again.
“If you actually look at the stocks that have done well in the UK market this year, they are the stocks where, it almost doesn’t matter where economic growth is, the revenue line is going to be about the same, which means they are great deflation trades.
“That’s consistent with the bond market this year, so it ties together. It might not be right, but it’s consistent. There is a message coming out of financial markets, it seems to us.”
As such, the managers say it is a tricky environment to find new opportunities for the portfolio as the valuations of quality long-duration stocks have become expensive.
They believe the recent pullback in the growth/value rotation is a result of US bond yields tapering off following the US Federal Reserve’s rate hike near the start of the year.
“Come the beginning of this year, you had the excitement going into February of whether the Fed would raise rates, and it did. Then everybody decided that was it,” Ward said.
“In theory, what the movement in bonds is telling you is that US economic growth and, almost by definition, global economic growth is going to disappoint relative to where expectations got to at the tail-end of last year. That tends to push investors back towards the deflation trades.
“Our predisposition is not to act rather than to act. I think we can understand why some of these things have happened, we’re just not convinced that it’s necessarily going to be the prevailing sentiment for the next two or three years.”
The four crown-rated CFIC CRUX UK fund has a clean ongoing charge figure of 1.12 per cent and yields 1.83 per cent.