Sentiment towards the UK stock market continues at a low ebb, but domestic fund managers are buying high-quality businesses at attractive valuations.
Hargreaves Lansdown’s latest Investor Confidence Index fell four points to 58, its lowest level since inception in 1995. That number is lower than at any point in the past 23 years, including the dotcom bust and the financial crisis.
“Brexit continues to dent investor sentiment towards both the UK economy and the stock market, even though the latter is globally diversified in terms of its revenue streams,” says Laith Khalaf, senior analyst at Hargreaves Lansdown.
Elsewhere, global fund managers are still underweighting the UK, although their allocation has ticked up by 4%, according to the Bank of America Merrill Lynch fund manager survey.
But James Balfour, co-manager of the Aviva UK Equity Income fund, has made a number of purchases in the year-to-date for his portfolio.
The fund aims to yield, and return, higher than the market average. The managers do this by seeking out high-quality companies trading on cheap valuations that are on a recovery mission.
“We believe cash flow re-invested over time and that consistent improvement in the business should deliver you the returns,” says Balfour.
So far this year, the fund has topped up its holding in Melrose (MRO) after its acquisition of GKN and has initiated positions in St James’s Place (STJ), Babcock (BAB) and Severn Trent (SVT) to name a few. Balfour recently talked Morningstar.co.uk through a trio of others he’s bought in 2018.
Cineworld (CINE)
Cineworld is a company that Balfour has owned before, but the recent reverse takeover of US rival Regal Entertainment spurred him on to invest once again earlier this year.
With the continued growth in popularity of online offerings like Netflix and Amazon Prime, as well as ever-rising ticket prices, people are going to the cinema less often.
That’s particularly true across the pond, and Cineworld management had previously spoken negatively about the US market, which made it even more of a surprise to Balfour when they shelled out £2.5 billion for Regal. But Balfour is backing management’s assessment that there is inherent quality in Regal’s business.
The turnaround strategy is simple and the fund manager notes they have already saved millions of pounds a year just by putting the purchase of lightbulbs on to one contract. Meanwhile, they have put in place an online ticketing system and made it more of an experience.
“Cinema visitation has been declining in the US, but if you just steady that, or turn it around slightly, these things should throw off cash,” he says. “The scale of the business means that it will take time, but they are focused on doing it at a steady pace.”
Shares are already up a third since Cineworld completed the Regal acquisition at the end of February.
Smiths Group (SMIN)
Engineering group Smiths is another on the recovery path that the Aviva fund has recently bought into.
Philip Bowman was appointed chief executive of Smiths Group in 2007, “essentially to split the business up”, says Balfour. However, Smiths has had a pension problem for a few years now, meaning whenever parts of the business were sold the proceeds had to be used to pay down the deficit.
Meanwhile, because they have been intent on selling divisions, the business had become under-invested in order to “leave some value on the table” for potential buyers. Therefore, “it wasn’t quite pulling through the organic growth”.
Now, that pension problem is “pretty much sorted” and the top-line has started growing again under new boss Andrew Reynolds Smith, who joined in 2015. “We all read the half-year report and, while there was some disappointment, fundamentally they are growing the business; this is a recovery,” adds Balfour.
There are still some businesses within Smiths that could be broken up – its John Crane’s Bearings division was offloaded for $35 million in January, while last week it broke off discussions regarding the sale of Smiths Medical.
Elsewhere, Smiths Detection is a high-quality business in a growing market: security scanners “are becoming more prevalent” worldwide.
“We don’t think the valuation is that expensive, compared to other engineers in this space,” concludes Balfour. Shares are up 5% year-to-date at 1,561p but have pulled back since hitting an all-time high at £18 in June.
IMI (IMI)
A similar story is playing out at fellow engineer IMI, which primarily makes valves for oil refineries. Mark Selway joined as chief executive in 2014, telling shareholders at the time that many of its businesses weren’t being run as efficiently as they could have been. He claimed he could turn this round, improving margins in the process.
Not long after, the oil price crashed from above $100 per barrel to around $20. Despite Selway having put in the foundations for the turnaround, the top-line then started declining alongside the oil market.
Balfour says: “We now think the market is in a better place, with oil above $80. They’re starting to see the top-line coming through and the work that has been put in over the last three years, which gets lost when the market’s going backwards, is there to come through and drive the margins of the business.
“They’ve almost done the self-help, they just haven’t had the top-line to see what’s been done. And, again, it’s not trading too high on valuation, there is a quality business in there that should generate the cash and continue to do so.”
Shares have recovered 9% from the four-month low they hit in April, but are still 16% lower year-to-date.
