July 2018

Thought For The Month

Some questions come up quite frequently when meeting clients.  Below we summarise our thoughts on those subjects which seem most contentious.

Isn’t Marks & Spencer in structural decline? How can it compete in food against larger competitors and in clothing against more nimble competitors? Have you been in its stores? Have you tried purchasing something on their website?

Yes, we agree the shopping experience at M&S is far from perfect. But without wishing to sound glib, that is the opportunity. We accept that the high street is under pressure and that M&S has plenty of high quality competition in both food and clothing. However, we believe a lot of the company’s current difficulties are as much self-inflicted, as they are a consequence of external issues. The new chairman, who describes the company as having a ‘burning platform’, has, together with the chief executive, highlighted a variety of challenges. These include excessive costs, poor IT, sub-optimal customer service, a sub-standard website, weak distribution infrastructure, a lack of innovation in food, an excessive number of clothing brands, too many stores and an insufficiently attractive choice of low priced items. Some of these issues have already been improved whilst others will take longer. Clearly a turnaround will not be straightforward, but much of its success appears to be in the hands of the management. The market believes a recovery is unlikely and expects profits to remain flat over the next three years. The shares are, given that scepticism, cheaply valued and, like much of the portfolio, could appreciate significantly if a recovery is engineered.

The government has started selling off its large holding in RBS. Won’t that keep a lid on the share price?

The market is well aware of the overhang and this should be discounted in the RBS price. It is interesting to note how well Lloyds Banking Group performed while the government was selling off its substantial holding. With further large sales probably only possible when RBS returns to the dividend list, it is important to think about future buyers as well as future sellers.

You have held Travis Perkins for a few years in the expectation of a recovery in the UK repair, maintenance and improvement markets (RMI). Its share price underperformance suggests it has missed it or it  hasn’t happened. Is it time to give up?

Travis Perkins’ operational and share price performances have been disappointing. The RMI market has not recovered as we had hoped, probably due to the continued low level of housing
transactions (which typically drives home improvements). It is possible that housing transactions are simply consolidating at a lower level – in which case perhaps homeowners will do more  work on their existing houses. Travis has also found competition hotting up from new entrants in its traditional markets and management may have been late to react, but now seems to have
got the message. Its DIY business Wickes has been even more disappointing, once again affected by a slow market and heavy competition. The ‘good’ news is that the shares are now so lowly
valued that no RMI recovery is really required. On consensus earnings for 2018 the shares are on a P/E ratio of 11 and an EV/EBIT (our favourite ratio) of 9. This looks very cheap for a well
invested market leader and could prove very cheap when the RMI market does pick up.

How attractive is your opportunity set of unloved stocks?

The UK market now seems to be particularly bifurcated. Loved stocks are trading at very high valuations, while unloved stocks are struggling to attract buyers at almost any price. And any stock
which disappoint tends to be sold down mercilessly. Consequently, this has increased the number of stocks in our opportunity set and provided us with several stocks to look at. For
example, we are currently considering Micro Focus, Playtech, Provident Financial, Saga and PZ Cussons – stocks which we’ve either never held or not held for many years. At the same time
continued underperformance in specific names such as M&S, SIG and Travis Perkins has provided us with opportunities to increase our positions.

Are you positioned for a hard Brexit or a soft Brexit?

The conventional wisdom is that those stocks stuffed with overseas earnings and/or defensives are best placed for a Hard Brexit. However, the beauty of stock markets is that they are
discounting mechanisms. So, my question back (and equally hard to answer!) is ‘how much of a hard Brexit is already discounted in share prices’. My answer would be ‘quite a lot’ – surveys tell us that UK equities are out of favour and, within that, those stocks most exposed to the cyclical parts of the UK economy are particularly out of favour. It seems that the market is certain a
hard Brexit would be bad for sterling, but there must be a chance that the worst of the depreciation has already happened. And perhaps a hard Brexit won’t be as bad as people think. Another
way of looking at all this is to try and relieve ourselves from the emotions of Brexit and substitute ‘a recession’ for ‘Brexit’. We are trying to find those stocks which look cheap on a through-the cycle basis i.e. not for next year but for an average year. And a cycle typically includes a recession. And the good news is on through-the-cycle numbers several stocks are getting cheaper.

Could it get worse for a portfolio seen to be vulnerable to a hard Brexit even if a lot is already discounted?

Yes, the market is a voting machine in the short term, as Ben Graham said. If sentiment weighs against the stocks seen as most vulnerable to a hard Brexit, they will see further share price
falls. However, if on our through-the-cycle earnings calculations this makes them even cheaper, we will get an opportunity to add more to the portfolio. Obviously, we should be careful what we
wish for, but we like it when investors act irrationally. This sometimes means we have to take some pain first, but it does allow us to add long-term value to the portfolio.

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