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Ask the manager - Our answers, edition 2

In what has been a truly exceptional period for markets and wider society, we have been inviting investors to get in touch with their questions. In our second and final edition, Mark Whitehead, Portfolio Manager, provides his answers.

Link to Edition 1
Mark Whitehead Portfolio Manager of Securities Trust of Scotland
1) How have equities performed compared to bonds in crisis, and what is your outlook for the two asset classes?

From the 20 February to the time of writing (10 July), the Barclays Bloomberg Global Bond Index (the broadest global investment-grade bond index) has outperformed MSCI ACWI by just over 9%.

MSCI AC World (SR) USD - Total Return

Source: Bloomberg, 2020

We believe it is crucial to view this in the context of the full economic cycle though, where persistently low rates have depressed the total return on investment-grade (IG) bonds (driven significantly by new issues having historically low coupons) and contributed to excellent total return on global equities (equities +169% versus IG bonds +32% over the past ten years).

MSCI AC World (SR) USD - Total Return

Source: Bloomberg, 2020

Over anything other than a short-time horizon, we have high conviction that equities will continue to dramatically outperform bonds, in aggregate. This is for several reasons. As we experienced through the previous cycle, accommodative monetary policy (through stimulus measures such as quantitative easing) drives down the cost of equity and so increases the price of equities.

We believe accommodative monetary policy can only be unwound over a very long time period, meaning this situation will likely persist for at least the next several years. With lower debt burdens, companies also have more scope to create greater economic value and increase capital returns to shareholders, driving further increases in total return to equity holders.

Finally, in terms of investors choosing an asset class to invest in, the value proposition of IG bonds (currently trading at record low yields), has never looked less appealing in comparison to long-term equity ownership. Hence those that don’t need to own them will likely choose not to. Again, we do not anticipate this changing while accommodative monetary policy persists.

MSCI AC World (SR) USD - Yield to Maturity

Source: Bloomberg, 2020

2) Have you changed your investment process during the COVID crisis?

No. Our investment process is cycle-agnostic and indeed we feel it has been validated by the robust income generated through the crisis, in contrast to many peers. Indeed, in this uncertain environment, the conviction we have that companies with sustainable income credentials should now become highly prized assets and create an exciting opportunity for income investors feels even more relevant. Likewise, we continue to believe the best way of generating sustainable and growing levels of income is from companies with strong balance sheets and long-term structural growth opportunities.

3) Brexit – what impact is this likely to have on your investment decisions?

Overall, we do not expect there to be a large impact on our investment decisions. That said, we recognise that the inherent uncertainty around Brexit will likely herald risks and opportunities that we may not currently anticipate. We will therefore be continuously appraising potentially relevant risks and opportunities as they unfold through the Brexit process and, where we believe risk-reward has meaningfully changed, we will not hesitate to act in the best interests of our shareholders.

As income-focused managers, we will of course be closely monitoring Brexit’s impact on the value of sterling. This is because significant swings in the value of sterling can materially impact planned shareholder distributions, and so may enter into our calculations when making investment decisions.

We do not intend to modify our gearing strategy which looks to use sterling debt to earn a yield pick-up from excellent quality, long-duration, sterling-denominated real assets with very low risk attached.

Outside of our gearing strategy, and on analysis of the geographical revenue exposure of our UK-listed stocks, we consider ourselves to have low absolute exposure to Brexit, and a well-balanced exposure relative to our peers and the market. This position has developed organically based on fundamental analysis and conviction within our global opportunity set, and is one we are currently very comfortable with.

Our investment process is cycle-agnostic and indeed we feel it has been validated by the robust income generated through the crisis...

4) ESG is mentioned a lot by investors, are these important factors in your thinking?

We believe well-managed companies that exhibit strong corporate governance and an awareness of environmental, social and governance (ESG) factors in their operations are more likely to be successful long-term investments. This sentiment isn’t driven by idealism, but simply by the reality that companies exhibiting strong governance tend to outperform over time1.

The sustainability of a company’s business model is critical to maintaining competitive industrial positioning and robust returns, but at the same time a company must effectively manage the needs of its different stakeholder groups. We believe our approach to assessing sustainability of all aspects of a company’s operations, helps us to identify strong management teams, understand their motivations, and determine whether their interests are aligned with minority investors. This can ultimately reduce the risk to the investment and our clients’ money.

Our goal is to take a clear view on the integrity of management and corporate governance from a very early stage. We do this by fully integrating governance and sustainability considerations into our standard research templates and including this as part of all our stock discussions. We believe in active and ongoing engagement with companies, raising any issues identified in our research and voting at company general meetings.

5) How will governments recoup the money spent propping-up markets? Will businesses in UK face higher taxes and will those strangle the economy?

We believe that the governments of the world’s largest economies will mainly take a cautious and long-term approach to unwinding and recouping stimulus spending. We expect their approach to reducing fiscal deficits to be investment-driven (i.e. spending to reignite economic activity and to close deficits through full employment). The European Union has clearly signalled this approach with its mooted €750 billion recovery plan, while in the US there is increasing support for a minimum $1 trillion infrastructure deal. We do not expect the UK government to consciously move in the opposite direction and would be surprised if the UK government initiated broad-based tax increases on UK businesses prior to post-COVID19 and Brexit stabilization, which could take several years.

6) In what will be a difficult period ahead for many businesses, how do you gauge a company’s resilience?

In the post-lockdown world, with credit lines squeezed and revenue streams still gradually recovering, liquidity will be crucial to the operational survival of many companies. What’s more, we have seen that COVID-19 has accelerated and exacerbated many of the disruption themes we saw playing out before the pandemic. In this sense, business models that were previously viable, may become increasingly untenable in the post-pandemic environment.

For us, this absolutely underlines the importance of the credit analysis which has always been fundamental to our investment process. Companies that experience difficulty meeting their interest payments or paying the principal of their loans are likely to make decisions that will hamper both their growth potential and their ability to pay their dividend.

Credit metrics allow us to understand debt servicing and repayment in the context of profits and cash flow. We examine interest cover, the level of debt to profits and the level of cash flows to debt. Leverage and capital metrics allow us to understand how the invested capital base of a company is structured. The higher the debt component relative to invested capital or assets, the higher the credit risk. Debt capital-structure analysis also allows us to see the different debt components and their magnitude relative to the profit base of the company.

This helps us understand a business’ debts in terms of what category they are, and whether they are short or long term. The greater the short-term debt components, the higher a company’s liquidity requirement needs to be, in order to finance repayment and therefore the greater the potential pressure on cash flow.

However, this credit testing is one part of wider matrix of analysis, which includes our unique income analysis also involving dividend stress testing and governance and sustainability analysis. We work closely with companies to help us understand the sustainability and resilience of dividend payments which are key to us delivering on our aim.

1The analysis of Environmental, Social and Governance (ESG) factors form an important part of the investment process and helps inform investment decisions. The strategy does not necessarily target particular sustainability outcomes.

Regulatory information and risk warnings

This information is issued and approved by Martin Currie Investment Management Limited (‘MCIM’). It does not constitute investment advice. Market and currency movements may cause the capital value of shares, and the income from them, to fall as well as rise and you may get back less than you invested.

The information provided should not be considered a recommendation to purchase a particular strategy, fund or security,  or to sell any particular security. It should not be assumed that any of the security transactions discussed here were or will prove to be profitable.

The analysis of Environmental, Social and Governance (ESG) factors form an important part of the investment process and helps inform investment decisions. The strategy does not necessarily target particular sustainability outcomes.

Investment trusts may borrow money in order to make further investments. This is known as 'gearing' and can enhance shareholder returns in rising markets but, conversely, can reduce them in falling markets.

The information contained in this article has been compiled with considerable care to ensure its accuracy. But no representation or warranty, express or implied, is made to its accuracy or completeness.

Past performance is not a guide to future returns.

The views expressed are opinions of the portfolio managers as of the date of this document and are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. These opinions are not intended to be a forecast of future events, research, a guarantee of future results or investment advice.