Confidant Summer 2021

Acting for clients as they would want to act for themselves

Summer issue 2021

C O N F I DAN T Save | Plan | Invest

Keeping calm

Handing it back

Sleeping soundly

Facing facts

Paul Killik on portfolio positioning, p4

Stephen Timoney discusses shareholder returns, p6

Our Wealth Planning roundtable, p12

An interview with Vicky Pryce, p19

Long range investing

Key themes for 2021 and beyond, p16

C O N TA C T S

Head Office

Other locations

46 Grosvenor Street, Mayfair, London W1K 3HN T: 020 7337 0777

Chelsea Guy de Zulueta 45 Cadogan Street, London SW3 2Q J T: 020 7337 0590 E: chelsea@killik.com

Richmond Ian King 2 Paradise Road, Surrey TW9 1SE T: 020 8948 7337 E: richmond@killik.com

Esher Paul Martin 9 Esher High Street, Surrey KT10 9RL T: 01372 464877 E: esher@killik.com

Kensington George Harrison 281 Kensington High Street, London W8 6NA T: 020 7603 3618 E: kensington@killik.com

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Private Client Team Simon Marsh, Fred Robinson, Kristian Overend, Michael Pate, James Dunn, Gary Meredith, Michael Berry, Julian Spencer, Jeremy Sheldon, Fabrizio Argiolas, Joseph Henry, Julian Chester T: 020 7337 0400 Killik Asset Management Graham Neale T: 020 7337 0008 Family Office Jer O’Mahony T: 020 7337 0664 Wealth Planning Svenja Keller 46 Grosvenor Street, London W1K 3HN T: 020 7337 0724

We are delighted to announce that as of Monday 19th July, meetings can take place face-to-face in any of our locations. We will remain fully available remotely from then too, but should you wish to come in please speak to your Adviser to arrange a suitable time.

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Registered office: 46 Grosvenor Street, London W1K 3HN. A list of partners is available on request. Telephone calls are recorded for regulatory purposes, your own protection and quality control.

This communication has been approved by Killik & Co for distribution to retail clients. The value of investments and the income from them may vary and you could lose some or all of your investments. Past performance of investments is not a guide to future performance. The tax treatment of investments may change with future legislation. Prior to taking an investment decision based on the content of this publication, investors should seek advice from their Investment Manager on the suitability of such investment for their personal circumstances. Killik & Co accepts no liability for any loss or other consequence arising from the use of the material contained in this publication to make investment decisions, where advice has not first been sought from their Investment Manager. Killik & Co has no obligation to notify a reader or recipient of this publication in the event that any matter, opinion, projection, forecast or estimate contained herein changes or subsequently becomes inaccurate, or if research coverage on the subject company is withdrawn.

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You may view our policy in respect of managing conflicts of interest on our website.

2 — Summer 2021

FROM THE EDITOR

Breaking the rules Tim Bennett Head of Education In my role, I periodically run short seminars and webinars for groups of school children. I am therefore embarrassed to admit that I don’t remember more of what I was taught at their age, a fact I put down to the passage of time, rather than any shortcomings on the part of my teachers. However, a few very useful things did stick, one of them being a mathematical short-cut called the rule of 72. In a nutshell, this states that for a certain range of growth rates, it is possible to estimate the number of years it will take to double a sum of money by dividing 72 by the number chosen. As an example, a growth rate of 5% will double the value of an initial sum after about 14 years (72/5).

Increase the rate to 8%, and that falls to about nine years (72/8), and so on. It is not pinpoint accurate, but it works fine as a back-of-envelope method.

The reason I raise this is that having mentioned it during a recent educational session, I started thinking about the way new investors, in particular, perceive risk and return when it comes to stock market investing. In my “How to Invest in

Equities” guide (editor@killik.com for a copy) I quote the Barclays Equity Gilts Study 2020, which reveals that UK stocks have returned 5.3% on average in real terms, over the last fifty years.

This beats gilts (3.4%) and cash (1%).

However, in order to have successfully captured that superior, inflation-beating return, investors would have needed to view risk through the right lens. In that context, useful as it might have been at school, a short-cut such as the rule of 72 needs to be handled with care.

A novice investor, for example, might impute from it that they can safely assume a steady level of return from stock markets over any time period.

Seasoned investors, on the other hand, will know that shares do not deliver their reward in this way unlike, say, fixed income bonds. Indeed, according to Barclays, their historic “variability of returns” across just one-year periods is huge. The outcome over the best part of the last century has been anything from heavily positive to deeply negative. That said, it has been at least somewhat positive more often than not, for the simple reason that stock markets have risen over time.

C OMING UP

Making headlines, p5 Spotting themes, p8 Finding ESG funds, p10 Talking QT, p15 Uncovering value, p22

Too many investors nonetheless pile optimistically into stocks, only to panic-sell the moment the market takes one of its regular dips. This is a shame because, as the investment time horizon is extended, not only does the historic variability of returns (a.k.a. “volatility”) from stocks start to narrow sharply, but so do the chances of losing money at all, or underperforming other asset classes. Indeed, by the time the Barclays study looks at relative returns on a rolling 20-year basis, the range of equity market returns has narrowed dramatically, with the highest and lowest outcomes both positive and above those from gilts and cash.

My conclusion? Mathematical shortcuts, such as the rule of 72, undoubtedly provide a useful way of simplifying what could otherwise seem a complex calculation. However, in the wrong hands, they can also mislead when it comes to setting investor expectations. A key part of the remedy is fortunately simple – investors need to commit to time in the market and keep faith in the long-term power of a diversified portfolio of equities, coupled with compound growth. ●

SECURITIES IN THIS ISSUE Amazon, Nestlé, Rio Tinto, p4 L&G ISPY Cyber Security ETF, p5 Danaher, Thermo Fisher, Xylem, p9 Royal London Global Sustainable Equity Fund, Pictet Global Environmental Opportunities Fund, First State Asian Equity Plus Fund, Schroder ISF Global Energy Transition Fund, p11 Dexcom, RenalytixAI, p16 Tesla, NIO, Northvolt, Chargepoint, Shopify, Meituan Dianping, Renishaw, IMImobile, p17 Unilever, Reckitt Benckiser, Diageo, p18 Brickability, Sureserve, p22 Studio retail, p23 Summer 2021 — 3

PERSONAL VIEW

Relaunching MyKillik Paul Killik Senior Partner Paul highlights our new client portal before cautioning investors against market timing.

The rapid advance of digital technology during the pandemic has been fascinating to watch. In the space of just over a year its acceptance and use has leapt forward by a decade. Most of us have had to contribute to this transition – under lockdown, communicating with our families, holding business meetings, sharing documents, ordering goods and services and finding TV programmes, could only be done over the internet.

Many people, who had never written an email before, realised they had to embrace everything from WhatsApp to internet shopping, streaming, and Zooming. Digital, in short, has become a way of life.

Against this backdrop, we realised that technology would become an even more important part of our services to clients and far sooner than we had previously considered possible.

We have therefore spent time during lockdown considering how we would introduce more technology, whilst not losing the human interface that we consider so important. We have felt for a while now that our existing portal was no longer fully fit for purpose, particularly with regards to our Segregated Services approach to portfolio management.

Unsatisfied with some of the limitations of an external build, about two years ago (and well before Covid-19 struck) we decided to develop the latest version internally. This puts us in a better position to explore the digital opportunities that new technologies are creating and will help us continue to innovate when it comes to delivering investment management and planning.

In that context, I am delighted that a great many of you have told us that the new MyKillik represents a significant improvement. However, I recognise that some have either 4 — Summer 2021

experienced difficulties with logging in or feel that the old version better met their needs. I apologise most readily to those of you that have encountered such issues. Do be assured that we are trying to better understand your needs, with a determination to give you the experience that you seek. To help us on that journey, please send your comments and any suggestions for improvements that you would like to see to clientsupport@killik.com.

Reducing rotation In recent months, the press has made frequent references to the supposed merits of rotating out of what they deem expensive “growth” areas of the market in favour of “value”, at either an individual stock or sector level.

I would urge you not to entertain such an approach as a long-term investor – it is no more likely to yield results than trying to anticipate a fall in the market by selling ahead of it, in the hope of buying back into it at cheaper prices later. Anyone who believes that they can consistently remain one step ahead like this is almost certain to lose money over time. This fact does not stop the many young professional investors working in the funds industry, or managing institutional capital, from risking other peoples’ money every quarter in an attempt to stay ahead of their benchmark. In the process, they lose sight of the fact they should be taking a long-term view. That is why so many active managers are outperformed by index trackers – they are simply too active. That said, index-matching or “hugging” is backward looking and buys yesterday’s successes. A far-sighted long-term active manager, on the other hand, with conviction about the direction of travel, should comfortably outperform such an approach over a decent time horizon.

Rotation is, nevertheless, a fact of investment life. So, how does our investment process overcome the fact that its popularity can sometimes lead to prolonged periods of lesser performance? Firstly, through a focus on the delivery of long-term capital growth. This means we target businesses that are exposed to attractive and enduring themes that, in aggregate, are capable of compounding earnings and cash flows by at least 10% per annum over a rolling 5-year period. That rate is well above the stock market’s longer-term average.

We also have a differentiated approach to growth, focused on identifying the type we expect a company to deliver and assigning holdings to one of three growth categories – Fast, Defensive and Cyclical.

As a snapshot, a typical Fast Growth company is Amazon which is benefiting from the rapid expansion of e-commerce, driven by operational performance rather than GDP growth.

Meanwhile, our Defensive Growth category encompasses names such as Nestlé, a durable global franchise that we expect to thrive in most economic environments, and which is being reenergized under a new management team. Our final category, Cyclical Growth, includes the likes of mining giant Rio Tinto. Whilst its performance is tied to macroeconomic and capital cycles, the firm should nonetheless benefit from longer-term rising copper demand across the power and construction sectors, alongside the increasing adoption of electric vehicles.

By blending these categories together within a portfolio, we aim to deliver consistent performance across the economic cycle. Further, by not chasing rotational swings, we can remain focused on the fundamentals that drive returns over the long-term. ●

Q U A R T E R LY R O U N D U P

Unlocking growth Rachel Winter Associate Investment Director Rachel sums up the key takeaways for investors from a busy Spring in global markets.

hacked the latter, a group of cyber criminals demanded and received a ransom payment of $4.4m in Bitcoin.

Share prices hit some positive milestones last quarter. US equities reached new all-time highs, European equities returned to pre-pandemic levels and the FTSE 100 index climbed steadily. Meanwhile, the OECD upped its forecasts for global growth again in 2021 to 5.8%, citing better than expected progress in the rollout of COVID-19 vaccines. Here in the UK, the level of household wealth has climbed to a record level, on the back of rising house prices and stock markets.

These recent examples highlight why firms must consistently strive to ensure they have adequate cyber security in place – a report published

by Gartner in May predicted that global spending will top $150 billion this year.

It highlighted cloud security as the fastest growing area within this space, reflecting increased usage of the cloud as more and more people work remotely. Related investments have duly performed well, for example the L&G ISPY Cyber Security ETF.

Increasing inflation However, the associated rapid pick-up in demand has also led to a rise in inflation. Recent readings in the UK, US and Europe have all surpassed consensus expectations. Here, the number for May came in at 2.1%, exceeding the Bank of England’s target for the first time in two years. In the US, the equivalent reading was 5%, the highest since 2008.

The key question for investors is whether we are seeing a temporary inflation spike, as economies rebound from very depressed levels, or the start of a more sustained rise in prices.

UK and US government bond yields offered a possible clue – they have not risen during the quarter, implying that bond market inflation expectations remained broadly unchanged at the time of writing.

Staying safe Following three high-profile hacks that have all been attributed to Russian criminal gangs, cyber security remains in the spotlight. The targets were the IT infrastructure behind Ireland’s healthcare system, the world’s largest meat processor JBS, and the huge US Colonial Pipeline. Having successfully

Creaking crypto Meanwhile, although the regulator here (the FCA) does not oversee cryptocurrencies, which considerably reduces their attractiveness as investments, the volatility of this asset class over the last quarter is worth noting. Bitcoin, for example, dropped substantially from its March peak, and for some pretty clear reasons.

Firstly, China banned cryptocurrency exchanges and initial coin offerings.

Then “Technoking” Elon Musk announced that Tesla would no longer accept payment in Bitcoin, owing to environmental concerns about the mining process. He subsequently revised his position by saying that the firm will accept payment in the cryptocurrency, provided it has been mined using sustainable power.

Further, global authorities have been discussing how best to tax this new asset class and make anyone profiting from it aware of their potential liability to capital gains tax. Finally, the US FBI revealed that it has recaptured most of the ransom that was paid to the hackers of the Colonial Pipeline, sowing doubt about the security of Bitcoin in the process.

Supporting sustainability Cryptocurrency mining concerns aside, investors’ growing enthusiasm for sustainability was demonstrated when shareholders in ExxonMobil voted against three board candidates put forward by the company. Instead, they expressed a preference for others nominated by activist hedge fund, Engine No. 1. The fund has been critical of Exxon’s lack of action on climate change and wants the new directors to steer the company down a greener path. The firm has lagged peers when it comes to reducing its dependency on fossil fuels and has been the worst performer of the “big five” oil majors (the others being Royal Dutch Shell, BP, Total and Chevron) over the last five years.

Fossil fuels were also high on the agenda at the latest G7 summit in Cornwall, where leaders from the developed nations agreed to help developing countries to reduce their dependence on coal.

Dissecting data Looking ahead, we wait to see how far consumer behaviour will shift as social restrictions are lifted.

Companies involved in online retail, digital payments and remote working technologies have all thrived during lockdown as people shopped online and worked from home. However, it is not yet clear to what extent these new habits will stick. Online retail sales, for example, accounted for just under 20% of the UK’s overall sales total for February 2020, ahead of the first lockdown. By February 2021 that proportion had risen to 36%, but in April it dropped back to 30% as consumers took advantage of physical stores reopening. Investors should keep a close eye on this sort of data as our freedoms are restored. ● Summer 2021 — 5

THE BIG PICTURE

Paying back Stephen Timoney Senior Analyst As firms emerge from the pandemic and resume payouts to shareholders, Stephen examines the case for returning capital and weighs up dividends against share buybacks as the mechanism for doing so.

One of the primary purposes for which companies are created is to generate an acceptable return on capital (“equity”) for shareholders in the form of earnings. The key question then becomes, what should happen once they do? There are two basic choices open to the directors – earnings can be retained and reinvested, or given back in the form of a dividend or a share buyback.

This is amongst the most important capital allocation decisions regularly made by company management teams, and a key determinant of long-term shareholder value creation.

With dividend payments resuming and buybacks on the rise, here is a snapshot of their relative merits.

Retaining profits “Retained earnings” are those that have been kept in a company, thereby increasing its equity (and net assets). However, although boosting this number for its own sake may suit ambitious directors, it is not necessarily the best course of action for a firm’s shareholders. That is because, as investors, they should always require a minimum return on their investment in a firm for a given level of risk. So, in principle, earnings should be retained only if they can be reinvested at, or above, that required rate. There are some circumstances in which companies may hang on to their earnings, despite delivering sub-par returns – to satisfy regulatory 6 — Summer 2021

requirements for example – but otherwise any “surplus” equity should be promptly returned. But how?

Dividing the spoils Cash dividends distribute equity through a simple disbursement of some, or all, of a company’s cash to shareholders. Share buybacks can achieve the same distribution of equity, but not solely in the form of cash. Instead, they involve a company acquiring its own shares, usually by buying them in the open market. These become “Treasury Shares” (in issue, but no longer outstanding), or are otherwise cancelled. Either way, the number included in the distribution of dividends and the calculation of earnings per share is reduced.

Conceptually, share buybacks can be thought of as using cash to ‘buy out’ one or more business partners, thus increasing the equity value attributable to the remaining ones. They therefore result in increased per-share ownership for non-sellers, while generating cash for sellers.

The popularity of each mechanism varies by regional market. In the US, for example, share repurchases surpassed cash dividends to become the dominant form of corporate payout in the late 1990s. Unsurprisingly, buyback activity slowed amid the uncertainty caused by the pandemic, as companies hoarded cash to protect their balance sheets. Nonetheless, the longer-term upward trend has resumed more recently with US companies announcing $484bn in share buybacks in the first four months of this year, the highest such total in at least two decades, according to Goldman Sachs.

Notable amongst them was Berkshire

Hathaway’s $18bn repurchase of its own stock.

In the UK, by contrast, dividends remain the preferred option. COVID-19 took a heavy toll, as around twothirds of companies cut or cancelled dividends between the second and fourth quarters of 2020. In that context, the recovery to date has been muted and, in contrast to the outlook for US buybacks, it will likely be several years before UK dividend payouts reach pre-pandemic levels.

Battering buybacks A common criticism of equity distributions to shareholders, of any sort, is that they divert money from investment in plant and equipment, or research and development, thereby stymying overall economic growth.

Overwhelmingly – and illogically – such criticism seems to be focused on share buybacks to the exclusion of dividends. In the US, the antibuyback viewpoint gained strong political momentum in the run-up to the presidential primary elections, with Senators Chuck Schumer of New York and Bernie Sanders of Vermont calling for a limit on them unless companies also raise worker pay, boost staff benefits and invest capital. Even Republican Senator Marco Rubio, of Florida, jumped on the bandwagon with a call for higher taxes on share buybacks. This barrage of criticism is, however, counterproductive.

Leaving aside short-term tax considerations, the decision to retain earnings, or to distribute them by way of a dividend or share buyback, is fundamentally linked to a firm’s year-to-year investment opportunities.

And, in the long-term, to the stage it

THE BIG PICTURE

has reached in its corporate lifecycle.

High-growth start-ups, for example, often have many attractive investment opportunities and will tend to retain earnings as a result. It makes little sense for such companies to return equity when it can be reinvested for the benefit of shareholders at high rates of return. Mature companies, by contrast, typically have established market positions with more limited options for growth. Their best course of action is often to return cash to shareholders, rather than commit capital to value-destructive investments or acquisitions. Regardless of their stage in the corporate lifecycle, however, all companies may find their investment opportunities constrained by the wider economic backdrop. Despite the political finger-wagging, buybacks may be a symptom, rather than a cause, of economic malaise. If so, politicians should not be forcing companies, in effect, to make bad capital allocation decisions.

Lining up Once a firm has decided independently to return capital to shareholders, the issue becomes how best to do it – through buybacks or dividends.

Both have their pros and cons.

According to the proverb, a bird in the hand is worth two in the bush. As such, dividends are a tangible distribution of equity to shareholders whose value, once received, is not subject to change. Share buybacks, on the other hand, are a less certain proposition.

Since the required transaction reduces the number of shares in a company, key ratios, such as earnings per share, get an automatic boost. However, provided a theoretical ‘fair price’ is paid for the shares, any gain in earnings is offset by a loss of cash for nonselling shareholders (and vice versa for selling shareholders), making it a break-even transaction.

But what if a fair price is not paid?

Buying back shares when they are cheap adds value for non-selling

obliged to keep making de facto ‘interest payments on equity’, even when there are better ways that they could be deploying cash.

shareholders, at the expense of those who sell. Conversely, share buybacks at a premium add value for selling shareholders, to the detriment of nonsellers. As such, it’s a zero-sum game.

Unfortunately, history shows that most share buybacks take place close to the top of market cycles, when rich valuations abound, and investment opportunities are few. To compound this problem corporate managers, like many other investors, appear to be reluctant buyers at market bottoms.

Buybacks, then, are more akin to the proverbial “two in the bush”: they can add value if they are carried out at attractive valuations, but they can also destroy it if they are executed poorly.

Timing trouble From a pure capital allocation point of view, however, share buybacks offer much more flexibility than dividends.

Ideally, companies would time them to coincide with a lack of investment opportunities and low share valuations.

What is more, once started, there is no obligation for a repurchase programme to be completed within a certain time frame. Dividends, by contrast, may be discretionary but they can bind management. As investors become accustomed to receiving regular payouts, and may even come to rely on them, any reductions, suspensions or eliminations can trigger drastic share price declines. This means that once regular dividend payments are established, management is effectively

Share buybacks also offer a tax advantage over dividends because the eventual profit is treated as a capital gain. This means that investors are in control of when they decide to sell their stock to take a gain, allowing them to postpone taxes in perpetuity by delaying, or set capital losses off against them as they are realised.

Moreover, in countries such as the UK, capital gains are taxed at a lower rate than income.

A darker side of share buybacks is that, while they only benefit shareholders when carried out at attractive valuations, company managers can exploit the mathematics to their advantage, regardless of market conditions. By tying their compensation packages to growth in earnings per share, the less scrupulous ones may be incentivised to buy back shares regardless of their valuation, perhaps at the expense of other attractive investment opportunities.

Thankfully, many companies try to mitigate this risk by either adjusting for the inflationary impact of buybacks in calculating pay packets, or aligning them to other, more shareholderfriendly measures, such as total return.

Nonetheless, investors should be on their guard.

Closing out In summary then, dividends and share buybacks respectively present advantages and carry certain disadvantages. Therefore, what ultimately should matter most to investors is not so much the chosen mechanism by which equity is distributed by a company, but rather whether such distributions stack up in the context of the prevailing investment environment. Management teams that judge this correctly will create the most long-term value for their shareholders. ● Summer 2021 — 7

EQUITY RESEARCH

Thinking thematically Andrew Duncan Senior Equity Analyst This quarter, Andrew takes two deep dives into our thematic approach to stock selection.

The Killik & Co investment process is built on harnessing thematic ideas.

It is an approach that requires us to identify economic, political and social trends that can offer above-market growth over time. By contrast, other investing styles may be geared towards short-term factors relating to the economic cycle, such as GDP growth and employment levels. These may manifest over just a few quarters or even months, whereas the secular themes we seek to capture via our investment strategy can run for many years.

This kind of approach is intellectually demanding, in that we must be prepared to peer further into the future than a typical investor. That, in turn, comes with a greater level of uncertainty and even margin for error – it is much easier to predict what the world will look like over the next week, rather than five years. However, we seek to counter this headwind by taking a thoughtful and conservative approach to our projections. Further, we believe that the long-term outperformance that comes from correctly identifying winning themes far outweighs any potential downside.

Seeking stability Naturally, we are not alone in our thinking. In 2021 there seems to be a theme for everything, and an associated investment vehicle to match, whether the underlying thread is cryptocurrencies, rising levels of global obesity, or even the space economy.

However, whilst not wanting to totally dismiss them, we nonetheless feel that investors should not 8 — Summer 2021

underestimate the risks of investing into what are, in some cases, nascent industries where the underlying companies have no clear path to profitability. Instead, our approach is built on looking for themes that have a relatively high level of predictably.

We therefore spend time on “Big Picture” thinking combined with detailed research and analysis, a strong pairing that makes a substantial contribution to our investment performance over time.

Once we have found a theme that we like, we then look for businesses that stand to benefit from secular tailwinds that should provide lasting opportunities for growth in revenue, earnings, and free cash flow. We keep the old investing adage in mind that, “a rising tide lifts all boats” even if the tide in our case is not the overall economy or a specific pocket of it, but a broad theme that we want to tilt towards. The businesses that we select must therefore be able to plan and invest for the long-term, whilst demonstrating the means to withstand any short-term volatility in their endmarkets or regions. As such, we are focused on high quality companies that can offer significant scale, balance sheet flexibility, strong brands, and robust growth opportunities.

As we enter the final stage of our re-emergence from the pandemic, here are two examples of key global challenges that demonstrate how the

thinking outlined above, positions us to deliver superior risk-adjusted investment performance.

Staying healthy The first is our Future Healthcare theme. The cornerstones of our investment case are several seemingly unstoppable global forces, which include a rising population (the UN predicts an extra 700 million people on the planet by 2030) and increasing need for, and access to, healthcare in emerging markets. This will create a wall of demand as not only are people living longer, but they are also becoming less healthy. That combination implies a higher incidence of chronic conditions, such as diabetes and heart disease which, in turn, are expected to place a greater strain on an already overburdened global system (in 2017, it was estimated that over one in seven dollars of spending in the US went towards treating diabetes alone).

These drivers strongly suggest to us that global healthcare spending will continue to rise consistently over the next decade and beyond.

Given the inherent uncertainty in developing new therapies or medical devices, it is often difficult to accurately predict which companies in this space will be able to deliver the next round of solutions. However, what we are convinced of is that all healthcare companies, both existing giants and emerging upstarts, will have to spend significant amounts of money as part of an important global effort. But rather than taking what we would see as undue levels of risk in buying companies facing uncertain success around their future products, we prefer to ride the existing wave of research and development (R&D) spending in the healthcare

industry, alongside long-standing trends towards greater outsourcing.

As such, Danaher and Thermo Fisher are two of the top names that help healthcare companies to research, develop and commercialise products across a wide range of end-markets.

Both are geared to traditional spending as well as promising future markets (including cell and gene therapies, for example). We believe that both companies can grow annual revenues in the mid-to-high single digit range over the medium to long term, underpinned by excellent commercial execution and the aforementioned secular growth in healthcare R&D.

Splashing out Within our “Sustainable Infrastructure” theme, the case for investment in water is quite simple: it is the finite, essential resource needed to sustain life. Further, the world needs to secure greater access to it in a useable, clean state in the face of some persistent, growing challenges.

Water demand is being driven by a rising global population, coupled with climate change and the associated variability in weather patterns.

In developed markets, ageing infrastructure presents a significant barrier to overcoming these issues.

Across the US, for example, it is estimated that the national average age of pipes has risen from 25 to 45 years between 1970 and 2020, largely as a result of underinvestment. Creaking infrastructure not only leads to greater leakage and pollution, it is also less efficient and more costly to run than its upgraded equivalent.

In emerging markets, meanwhile, water infrastructure is still non-existent in some countries and regions. The UN estimates that over four billion people lack access to basic sanitation, whilst over two billion are deprived of safely managed drinking water. Gaps in regulation around pollution, combined with a lack of adherence to existing ones, further complicate the picture.

EQUITY RESEARCH

Against such a backdrop, spending on water technology must continue to grow steadily over the coming decade, to improve existing infrastructure and meet these growing challenges. This combination of solutions is what our favoured water technology companies are all about.

Biden time However, there is also the potential for a significant separate boost in spending across developed markets from the $110bn earmarked for water infrastructure as part of President Biden’s $1.9tn proposed government spending plans. Our approach to this is nonetheless conservative – whilst we have confidence in the eventual increase in spending needed, there can be no certainty about its timing and extent beyond the headlines.

Despite a growing awareness of environmental and regulatory issues, several decades of underinvestment have already passed, increasing our reluctance to assume that this time will be any different. So, rather than baking a significant step-up in spending into our forecasts, we prefer to remain circumspect. Should a significant new infrastructure replacement programme materialise in the medium term, this will likely boost our investment case. If not, the challenges facing this crucial industry will remain. Our thematic work suggests the sector will generate attractive opportunities for investors regardless.

For now, our favoured way to invest is via Xylem, the world’s largest pureplay water company. With a product range spanning pumps, meters and treatment, plus data and analytics, it is geared to the replacement and upgrade cycle in hardware (mainly pumps), as well as the newest and smartest connected solutions aimed at reducing waste and improving asset efficiency.

For more information on any of the companies mentioned in this note, please contact your Investment Manager. ●

Killik & Co Security Risk Ratings All research recommendations are issued with a security-specific risk rating, represented by a number between 1 and 9. Assessing the relative risk of any security (specific risk) is highly subjective and may change over time. The Killik & Co Risk Rating system uses categories which are intended as guidelines to the specific risks involved, as follows: 1. Restricted Lower Risk Securities in this category are what we believe to be lower risk investments such as cash, cash equivalents and short dated gilts, and the collective investment vehicles that invest in those instruments.

2-3. Restricted Medium Risk Securities in this category are what we believe to be medium and lower risk investments including medium and long-dated gilts, investment grade bonds and certain collective investment vehicles investing predominantly in these securities.

4-9. Unrestricted Securities in this category are what we believe to be higher risk and are drawn from across the United Kingdom and international markets. These are normally direct equity investment and collective investment vehicles which predominantly hold securities other than investment grade bonds and money market instruments.

The vast majority of the Killik & Co Research recommendations are likely to fall in the unrestricted/ higher risk category (4-9) above.

For further details on the Killik & Co Risk Rating system please see the Killik & Co terms and conditions.

Summer 2021 — 9

FUND RESEARCH

Cleaning up Gordon Smith Head of Fund Research Gordon analyses the growth of “Responsible Investing” and flags some of the key considerations for fund investors.

Over the last few years, we have seen a marked increase in the formal adoption of Responsible Investment practices across the asset management industry.

Fund flows into this area have been correspondingly significant, with a notable growth in the range of strategies being deployed right across the spectrum. This reflects the fact that more and more investors are seeking to either exclude less ethical areas of the market from their portfolios, or to increase their exposure to important thematic trends such as renewable energy, water sustainability and natural resource efficiency.

The overall direction of travel is clear from the growing list of signatories to the UN Principles for Responsible Investment (see chart). In 2020, the number of global asset managers signed up to the principles set down by this independent body rose above 3,000, which represents over $100trn of assets worldwide. By accepting them, money managers have shown a commitment to incorporating Environmental, Social and Governance (ESG) criteria into their investment processes and recognised that a range of non-financial factors are increasingly important in identifying opportunities and risks.

As such, this is no short-term fad.

Indeed, we believe that ESG could benefit for some time from a rising share of investor fund flows. There are now clear reasons why businesses with better ESG credentials can generate stronger returns. Key amongst these is the fact that they are less likely 10 — Summer 2021

to be targeted by regulatory policy as governments around the world tackle issues such as climate change, health and inequality. Further, investor expectations for more sustainable revenue streams from such businesses should support premium valuations.

Muddying the water Unfortunately, the terminology used to define the various elements of Responsible Investment is rarely consistent. Meanwhile, the sheer breadth of the spectrum of activities encompassed by this sector can lead to confusion. For example, some fund strategies adopt a relatively light touch when it comes to negatively screening, or excluding, the less ethical industries, such as tobacco, adult entertainment and weapons manufacturing. Others will aim to favour those firms with better ESG credentials than their peers when it comes to portfolio construction.

Moving up the spectrum, there are then fund strategies underpinned by more strongly positive investment choices, which focus on businesses that are actively addressing one or more of the sustainability challenges around the world. The sector also spans mandates with a focus on social impact and philanthropy, albeit they fall outside of the scope of our research.

Against this backdrop, the recently implemented Sustainable Finance Disclosure Regulation seeks to enhance the sustainability-related disclosures made in relation to financial products such as funds. It also aims to formalise the two broad groups of Responsible Investment strategies mentioned above, as part of the European Commissions’ Action Plan on Sustainable Finance.

Whilst the resulting framework does

not impose any changes to the way products are managed, it requires products which have met certain ESG criteria with respect to their investment process or objectives to be classified as either “Article Eight” or “Article Nine” (with the remainder being “Article Six” or “Other”). The first category captures those which consider, or actively promote, environmental and social characteristics in the ultimate pursuit of financial objectives. The second focuses on those that seek to make a positive impact on society or the environment through sustainable investment and have non-financial objectives at the core of their offering.

Treading carefully Helpful as this is, the sheer variety of strategies that fall within the Responsible Investment category means they nonetheless come with a wide dispersion of return and risk profiles. These need to be weighed up when adding funds to portfolios.

Many of the ESG or ethical strategies (i.e. Article Eight funds), which implement “negative screening” through the investment process, can still maintain a broadly diversified exposure across most of the market.

For example, a wide range of ESGscreened regional exchange traded funds are available on the Londonmarket. A comparison of their strategies with the relevant, more traditional, index trackers reveals a similar volatility profile. Meanwhile, those that have adopted a greater sustainability or impact-focused investment process (i.e. Article Nine funds) will usually differ more markedly when benchmarked in this way. That is because managers who target specific environmental themes tend to invest in smaller, less

FUND RESEARCH

mature businesses whose greater return potential is typically accompanied by higher levels of volatility.

There are several other challenges around fund selection in the Responsible Investment sector.

Ethical considerations are ultimately personal to many investors, meaning that they need to marry a strategy with their own core values. It is also somewhat more difficult to compare portfolios on ESG or sustainability grounds than it is on more conventional ones. Unlike purely quantitative analysis, where an aggregate measure can be calculated to show a portfolio’s valuation or financial performance, qualitative sustainability analysis is often more subjective. Fortunately, thirdparty researchers continue to develop tools to aid the investment community in analysing and scoring individual companies as a way of assessing portfolios. They are being helped in this by the rising number of firms that offer greater levels of reporting disclosure, often in standalone publications dedicated to sustainability.

However, there is not yet a universal standard governing such reporting and so careful interpretation is still needed.

These considerations notwithstanding, many of the funds that we cover embed ESG within their investment process and we have recently added some new fund strategies to our recommended list. Four of these are highlighted opposite. ● Total assets under management (AUM) and number of new signatories to UN Principles for Responsible Investment (PRI) 3,500

120

3,000

100

2,500

80

2,000

60

1,500

40

1,000

20

500

0

Source: Federal Reserve.

2019

The table below offers a snapshot on four growth funds from our coverage list. As well as meeting our ESG criteria, all form part of our Alternative Allocation and Alternative Income managed services, which aim to provide protection within portfolios against the possibility of higher future inflation. Please speak to your Investment Manager for further details.

Royal London Global Sustainable Equity

Pictet Global Environmental Opportunities

Fund Type

UK OEIC

Fund Type

Luxembourg OEIC

Manager(s)

M Fox and G Crowdy

Manager(s)

L Diana and G Micheli

Fund Size

£132m

Fund Size

£7.08bn

KIID Impact on Return

0.72%

KIID Ongoing Charges

1.12%

Historic Yield

0.1%

Historic Yield

0.0%

The Global Sustainable Equity Fund’s investment objective is to achieve capital growth over the medium term (considered as a period of three to five years). It does this by investing globally in the shares of companies that are deemed to make a positive contribution to society and meet the management team’s ethical and sustainable investment policy. The process they apply to achieve this is built around positive screening, however, their strategy also explicitly excludes certain sectors and industries. Risk Rating: 5

This open-ended fund adopts a global, benchmark-unconstrained, active and long-only equity strategy. The overall aim is to generate long-term capital growth via superior riskadjusted returns, whilst achieving a positive environmental impact when compared to the global equity market. The fund invests in firms which provide products and services that help to reverse ecological damage and increase resource efficiency. Being European domiciled makes it an Article Nine fund (see page 10) under SFDR. Risk Rating: 6

Total Return (since launch)

Total Return (last five years, indexed)

150 140 130 120 110 100 90 80 70

Feb 2020

Oct 2020

June 2021

250 230 210 190 170 150 130 110 90

2016

2017

2018

2019

2020

First State Asian Equity Plus

Schroder ISF Global Energy Transition

Fund Type

Irish UCITS

Fund Type

UK OEIC

Manager

M Lau and R Jones

Manager

M Lacey

Fund Size

£3.4bn

Fund Size

£290m

KIID Ongoing Charges

1.06%

KIID Ongoing Charges

0.70

Historic Yield

1.8%

Historic Yield

0%

2021

The First State Asian Equity Fund invests primarily in the shares of companies based in the Asia Pacific Region (excluding Japan) of any size or industry type. It targets firms offering the potential to pay a regular income whilst generating long-term growth. The team integrate ESG analysis into the investment process, with sectors that cause direct harm to society being immediately excluded. As a European domiciled fund, it is classified as Article Eight (see page 10) under SFDR. Risk Rating: 5

This open-ended fund aims to provide capital growth by investing in the equity securities of companies worldwide that the manager believes are associated with the global transition towards lower-carbon sources of energy. The managers invest across a range of areas including generation, storage, transport infrastructure and distribution. The European domiciled version of this fund is classified as Article Nine (see page 10) under SFDR. Risk Rating: 6

Total Return (last five years, indexed)

Total Return (since launch)

250

250

200

200

150

150

100

100

50

2016

2017

2018

2019

2020

2021

50

Jul 2019

Jan 2020

Jul 2020

Jan 2021

June 2021

2020

2017

Assets under management (US$ trillion) [RHS] Number of Signatories [LHS]

2018

2016

2014

2015

2013

2011

2012

2010

2009

2007

2008

2006

0

Key fund data and charts

All chart data source: Bloomberg. Chart data to 2 July 2021. For details of the Killik & Co risk rating system, please refer to page 9. Figures stated gross. Past performance does not guarantee future results.

Summer 2021 — 11

W E A LT H P L A N N I N G R O U N D TA B L E

Getting ahead Svenja Keller, Will Stevens and Dan Fellows

Our Head of Wealth Planning recently caught up with Will Stevens, a Financial Planning Manager and his colleague Dan Fellows to discuss how we can all improve our personal finances post-pandemic.

where their hard-earned money is going.

The end-goal is to be able to answer the question, “how much do I have left over consistently every month?”. With that information, they can start to build a robust savings strategy.

Why is budgeting so important?

None of this is as laborious as it might sound. The advent of open banking means that there are plenty of apps available to help people to keep on top of what they are spending. That said, I personally prefer a good old-fashioned spreadsheet. Either way, the objective is to build a proper picture of someone’s outgoings and start to differentiate “needs” (the things they have to pay for) versus “wants” (items they spend money on out of choice). It is the latter category that often throws out opportunities to boost savings without turning our clients into misers!

Will: In a nutshell, budgeting is the foundation stone of any financial plan.

Identifying a surplus each month, however small, is the key to saving or investing for the future.

What the pandemic has taught everyone is that, whilst it is important to systematically identify specific longterm goals, such as how to fund life after work or cover school fees, and then build up the capital that will pay for them, most people should also be saving so that they have a buffer available when things suddenly go wrong.

I sometimes liken the start of the budgeting process to someone thinking about the best way to lose weight.

Their first step would be to identify how much they are consuming versus the energy they are burning. A snapshot of a single day will not be enough to build up a reliable picture – they will need to review their net calorie position over a meaningful time period. Without that information, a long-term weight loss program will probably fail.

By the same token, while many people have a clear idea about their regular income – whether from an employer, property, investments or selfemployment – too many focus solely on the day-to-day when it comes to thinking about what they are spending.

They could build a much more robust view by looking at expenditure systematically on a weekly, monthly and annual basis to properly understand 12 — Summer 2021

The first port of call for any surplus we identify from this process is a rainy-day fund to cover emergencies.

The amount varies but roughly three months of regular expenditure is a good minimum. The idea is to have an instant-access pot ready for problems which can range from a broken boiler to unpaid time off work to look after a sick child (this can create headaches for the self-employed in particular).

Over the last twelve months, people who may once have assumed they had a secure job have faced the additional threat of being furloughed, made redundant, or both in sequence.

Indeed, I can think of three clients who have all lost their jobs within the last twelve months. They were working in a range of different sectors and at varying seniority levels. Fortunately, they had something in common, aside from suffering the initial shock of redundancy – a cushion of emergency funds.

One of the trio worked in the finance industry and struggled to find a new position in the middle of a pandemic as businesses dragged their heels on recruiting expensive, senior hires.

The key to his financial stability in the interim was not only having a rainyday fund set aside but also being able to quickly adjust his expenditure downwards with the help of a detailed spreadsheet. He knew where he could shave costs by, for example, taking his mortgage payments down to the minimum level, rather than overpaying as he had been, reducing his spending on expensive wines, and cutting out various other nonessential luxuries.

Do people on high incomes need to worry about budgeting?

Svenja: Definitely. There is a tendency for some people to think “I’m on a big income, so I should be able to afford what I want.” However, once people start cranking up their spending, even a large salary can quickly disappear to the point where I meet young highflyers who cannot fathom why they are unable to build up a property deposit.

P E R S O N A L V I E WW E A L T H P L A N N I N G R O U N D T A B L E

Part of the reason for this is that successful people are often not as frugal as they believe they are being. Once everything is laid out in front of them in a spreadsheet, they can be shocked by quite how much money is disappearing on maintaining a certain lifestyle. Of course, my subsequent advice to someone earning £200,000 per year will be different to someone earning, say, £50,000 but it is surprising how fast people can develop spending habits that will absorb any salary and leave little left over.

The other point worth making is that some of the busiest people I meet often have little real idea about where their money is going. In all likelihood, they don’t have enough spare time to worry about it. This is a real shame as it is the early years in someone’s career that count the most when it comes to benefitting from the long-term power of compounding investment returns. The more they can save at that stage, the better.

How can someone reset their normal spending?

Dan: The pandemic has offered people the chance to reconsider what they spend and why, even if the opportunity to do so has not come about out of choice. If I had asked someone at the start of 2020 what they deemed to be “essential” expenditure, they would probably have come up with a much higher number than they would today. One of the few good things to come out of this testing recent period is it has focused people on quite how much money they may have been frittering away on everything from coffees to expensive treats and trips. Whilst I am not saying these must all disappear as we unlock, I would hope that more people can see more clearly how to balance up living for today with saving for tomorrow.

For most people, this involves some trade-offs, but they do not have to be painful ones. For example, saving

down their cash reserves. Naturally there is a balance to be struck here, since no-one wants to be loaded up with unnecessary and expensive insurance. Nonetheless, part of my role is to spot gaps and at least discuss them before suggesting ways to fill them cost-effectively.

on day-to-day spending now might mean someone can stop work a bit earlier than they expected, or give their children more financial support in the future.

What else should people be thinking about?

Dan: There are various insurance products available that can provide useful additional protection to individuals and families. However, they remain unknown, and even unloved, amongst some segments of the population perhaps because setting up the right one is often best done with the help of a specialist. Also, some people assume that once they have taken out life cover, as required by a mortgage company, it is job done as far as financial protection goes.

What they miss is the fact that our chances of dying – which is what life cover deals with – are a lot lower than becoming incapacitated or developing a long-term illness. Yet, these are scenarios that many people ignore, willingly or accidentally. It is also easy to forget that as we gradually acquire responsibility for other people, such as children, parents and maybe even siblings in some cases, our requirements change. The last year has also been brutal on the jobs front for anyone working in hospitality, for example. Those with no cover in place may have quickly found that they ran

We can also help when it comes to choosing between the various forms of cover, which can be broadly split into life assurance, critical illness cover and income protection. People need to think about all scenarios before they decide which of these they may need. For example, what would happen if they lost their current job through ill health or injury and subsequently had to take something less well paid? Or what would happen if the higher earner in a couple could not work for a period and their spouse needed to step up their financial contribution? Suddenly a working couple might be facing additional childcare costs for an extended period.

And whilst there are different ways to manage that challenge, we do at least need to think it through with our clients.

As an example, I pointed out to a client of mine during a recent review that she may be underinsured. Whilst her employer provided a suitable level of life assurance, she was largely on her own when it came to critical illness and income protection cover. Initially she decided to ignore my advice on the basis that the monthly premiums I was quoting were too high. However, a few months later she came straight back looking to set up the policies I had recommended.

The reason? She was working for a start-up that provided minimal sickness and other benefits and had seen several colleagues suffer financially when they were forced to take time off work during the pandemic. Now she views what might have been classed as a marginal product in her mind fifteen months ago as an essential one.

Summer 2021 — 13

W E A LT H P L A N N I N G R O U N D TA B L E

A second example is a client who works in the hospitality industry at a corporate level. Having enjoyed career success in the past, he has had a rough time of it over the last three years, with two redundancies. Following those experiences, he came to see me with his wife to put the right protection in place, separate to anything offered (or not, in his case) by his employer.

What other aspects of family protection are worth considering?

Svenja: Later life is another vital phase that is often poorly addressed. Here, I will just focus on the important issue of what happens when someone can no longer make their own decisions.

This type of challenge affects not just the individual but also the wider family since someone will be called on to step in and take responsibility for them and their finances when it happens.

For example, I dealt recently with a couple where the husband’s mother started to develop an aggressive form of dementia. They had been looking after her successfully for some time at home but suddenly her condition changed. Unfortunately, there was no power of attorney in place at a time when the level of medical and daily nursing assistance she needed was escalating rapidly. That meant that no decisions could be taken on her behalf even as she became incapable of making any herself. In the end, the couple had no choice but to go through the courts to try to get permission for her to go into nursing care, something she was refusing because she didn’t want to leave her own home. She ended up being very well cared for, once the move had been authorised, but all parties endured a lot of emotional distress in the meantime and home care had to continue until a judgement was reached. This is one of many cases I have dealt with that make the case for lasting powers of attorney.

Although the immediate priority in this 14 — Summer 2021

instance was health and welfare, I think it is important to have both types in place – that one, plus another covering financial and legal matters. There is a cost involved and it takes a while to set them up but compared to the time and expense of going through the courts later, it is well worth it.

Advisers are there to help people get them right because I know from experience that even dealing with the Office of the Public Guardian, who register these documents, let alone the courts later, can be painful if mistakes are made. Although the forms appear simple enough to fill in, there are nonetheless some traps for the unwary. Just one example is the decision about the number of attorneys appointed and how they will be able to act on your behalf – independently or by unanimous agreement. What works in a relatively calm environment may not when emotions are running high. Then there is the sequencing of signatures, which all must be gathered in the right order.

The process can be a bit of a minefield in short.

By contrast to the situation facing the couple I described earlier, I had until recently been dealing with a lady who was very organised and had set up powers of attorney. Her husband had passed away and she eventually ended up in a nursing home herself.

At that point, her daughter expected to be able to take everything over

smoothly but found that her mother had left vast numbers of hand-written notes attached to all her paperwork at home. As a result, it took ages to work through her many share certificate, bonds and bank accounts to piece together a clear picture of what she owned. Sadly, what she had understood to be a simple system to follow was less so for her uninitiated daughter. The takeaway here is that people should try to consolidate their finances as far as possible, in case someone else needs to take control, but also remember to brief someone they trust on how everything has been left.

Dan: I would add that people should think about powers of attorney from the moment they start to own assets in their name, other people become involved in their lives and dependent on them, or their circumstances change. It is an area we would look to review alongside shorter-term protection so that people are fully covered against most eventualities.

There is little to fear here – financial powers of attorney, for example, do not have to come into force immediately and medical ones can only be activated once someone is deemed medically incapable of making their own decisions.

Will: By way of a wrap up, I would like to emphasise the importance of thinking as widely as possible by, for example, considering contingency planning for a business owner. We have talked a lot about individuals and families, but it is important not to overlook issues such as how someone would keep, say, a small family business running if something happened to them.

As neutral third parties, we try to see things from every possible angle in our Adviser role. That way we can ensure that our clients are adequately protected or have at least weighed up all the risks should they decide not to put anything in place. ●

BOND RESEARCH

Going full circle Mateusz Malek Head of Bond Research Mat considers whether and when Central Banks may change direction when it comes to monetary policy support.

As lockdowns lift and economies reawaken after the global pandemic, investors are keeping a close eye on central banks and weighing up whether they may start to reverse ultra-accommodative monetary policy.

However, we believe that they are unlikely to do so any time soon.

Revisiting QE Since the outbreak of the COVID-19 pandemic, major central banks have been accumulating vast quantities of bonds. A reduction in the pace of these purchases – via what is called ‘tapering’ – has been attracting attention albeit, at the time of writing, the US Federal Reserve (“the Fed”) was still buying $120bn of bonds per month and the Bank of England £3.4bn worth of government bonds per week.

On top of that, central banks have been reinvesting principal repayments from maturing bonds in full.

The idea behind all this quantitative easing (QE) is simple – by buying huge amounts of bonds, they aim to reduce the rate, or “yield”, on them. The intended impact is to lower the cost of other borrowing by proxy, including mortgages and commercial loans.

That should mean that businesses and consumers are able to borrow more while spending less on servicing debt, delivering boosts to consumption, investment, economic growth and job creation. The side effect of this is to stimulate inflation, therefore helping central banks achieve their inflationary targets. QE programmes have also played an important role in boosting investor confidence, since they are typically unleashed during times of market stress.

Maintaining support Nonetheless, few people ever expected that what started as a

Fed, ECB, BoJ, BoE Balance Sheets ($tn)

an unappealing prospect in a highly leveraged world. Moreover, since the prices for perceived safe assets, such as government bonds, tend to be lower during recoveries than they are during recessions, central banks would have to sell their bonds below their purchase prices and bear the associated capital losses.

10 9 8 7 6 5 4 3 2 1 0 2007 Fed

2009 ECB

2011

2013 BoJ

2015

2017

2019

2021

BoE

Source: Bloomberg.

temporary policy, would become such a permanent part of the economic landscape. Thirteen years after the Fed launched its first QE programme, central banks’ balance sheets are holding more government debt, mortgage-backed securities, and corporate bonds than ever before (see chart). Indeed, the major central banks are now the largest bond holders in the world. The Bank of England, for example, owns nearly a third of all UK government bonds outstanding, more than all insurance companies and pension funds combined. Its holding includes 70% of some individual gilt issues, alongside £20bn of investmentgrade, sterling corporate bonds.

Further, central banks have never managed to meaningfully reduce these QE holdings. An attempt was made in early 2018, when the Fed stopped reinvesting some (but not all) principal bond repayments. Between October 2017 and August 2019, its balance sheet shrunk by roughly 15% as a result, albeit that still left it around four times the size of its pre-2008 value.

But that reduction did not last long – as the COVID-19 pandemic erupted, emergency action has led to a further doubling of the Fed’s balance sheet, to nearly $8tn.

Exiting slowly As such, a full exit from QE seems very unlikely. If it has successfully stimulated the global economy, then unwinding it would potentially deflate growth,

To avoid this, they could hold the bonds they own through to redemption at “par” and not reinvest the proceeds, in a repeat of 2018. However, with maturities often stretching to more than 50-years (for example, the Bank of England holds 55% of the 1.625% 2071 gilt), it may take a very long time to fully exit QE this way. Meanwhile, the global economy could encounter new shocks that demand further action. Alternative approaches have been suggested, such as cancelling QE holdings, or swapping them for zero-coupon, perpetual notes. The problem is that these initiatives risk undermining central bank creditability and independence and could even put commercial bank reserves at risk.

Moving forward The reality, therefore, is that it is unlikely central banks will ever return their balance sheets to pre-financial crisis levels. Moreover, should another economic shock arrive, they may consider purchasing higher risk assets, including corporate bonds and even equities, as they are arguably easier instruments to exit later given prices tend to recover relatively quickly once a crisis abates. And whilst the Fed has recently announced its plans to wind down a $13.8bn pandemic corporate credit facility, which holds individual bonds as well as corporate bond ETFs, its other QE programmes are still operating at full tilt. Meanwhile, the precedent for equity purchases has already been set by the QE pioneering Bank of Japan, which has been purchasing Japanese equity ETFs since 2010. We will therefore continue to monitor this space with interest. ● Summer 2021 — 15

FUNDS IN FOCUS

Identifying trends Gordon Smith Head of Fund Research At a webinar earlier this year Gordon talked to four fund managers about some key global themes and how investors can best position themselves to take advantage of them. Here are the highlights. For further information about any of the funds mentioned, please speak to your Investment Manager.

Dan Mahoney, Co-Head of Healthcare at Polar Capital

How much of a threat do virus variants pose to the post-pandemic recovery?

Even as the original vaccines were being developed, there were some concerns that their clinical efficacy would not be matched in the real world. In practice, however, they are protecting people well so far. The issue of virus mutations will, nonetheless, hang over us for some time. My view, based on my work as an immunologist earlier in my career, is that the T-cell response that vaccines trigger is crucial – it kills the virus, which is why the data, particularly once people are fully vaccinated, is so positive. I do not therefore expect mutations to have much of an impact in the short-term at least. I accept that some of them are capable of effecting what is called the ‘antibody response’, making some variants more transmissible from one person to another.

However, the vaccines that are already available should continue to substantially reduce hospital admissions and deaths.

How is the sector responding to changes in healthcare delivery?

The underlying changes were underway well before the virus struck but the difference is that they are now being implemented at pace. One is the ability to interact with a doctor remotely via 16 — Summer 2021

“telehealth”. This is moving the delivery of healthcare to cheaper and more efficient points of use, whether that is a GP surgery, a pharmacy or into someone’s home, all with the help of technology.

This has big ramifications for investors.

For example, the companies that are developing sophisticated outpatient treatment products, which facilitate local day surgery rather than lengthier and more remote hospital visits, should now be firmly on the radar. As fund managers we must therefore think about not just the range of treatments that may become available but also how they will be delivered.

Is there now a greater emphasis on preventative measures and diagnostics?

Certainly. Part of that is down to the improved use of data to “triage” patients so that better decisions can be made about who needs acute care and when.

Technology will help medics to keep people out of hospital who do not need to be there so that higher priority cases can be treated. A specific example of a firm in this space is Dexcom – their Continuous Glucose Monitor measures the sugar levels in the blood for a diabetic, helping them to manage the condition better themselves. Another would be RenalytixAI, a firm that focuses on people who have been diagnosed with type 2 diabetes. A small proportion rapidly develop chronic kidney disease, which presents an expensive treatment challenge. RenalytixAI’s diagnostic blood test markers, coupled with some clever AI-based analysis, help them to predict which sufferers should therefore be sent to a specialist as a matter of priority.

This potentially game-changing approach is typical of the innovation we are seeing across the healthcare space.

Tom Slater, Head of US Equities at Baillie Gifford and co-Manager of the Scottish Mortgage Investment Trust

What do the latest global energy trends mean for investors?

The current buzz-phrase “energy transition” describes a process that will last decades. We are already using a lot less energy than many predicted at this point in our economic development. That is being reflected in the energy intensity of GDP growth, which has slowed massively, as rising costs from conventional sources have collided with big environmental concerns.

Meanwhile renewable prices keep dropping – solar energy-generation costs have fallen by about 20% a year for the past decade. Elsewhere, the cost of storing energies in batteries has declined by around 16% for every doubling of global capacity. The result has been an explosion in demand.

From an investment perspective, however, there are several challenges.

Spotting the emergence of new ways of doing things does not create an automatic investment case – we also need to be able to identify the lowest price producers that have a sustainable competitive edge.

Take Tesla, which we have owned for most of the past decade.

They have successfully shown that there is a huge latent demand to be tapped for electric vehicles (EVs) provided the product and the process needed to manufacture at scale are right. However, success inevitably breeds competition. That is why we also own NIO, one of the largest manufacturers of EVs in China.

The Chinese market is hugely

PERSONAL VIEW

are operating in the UK on 20th-century systems, they have entered the 21st. We cannot compete with either the scale or speed of their rollout in the West.

How rapidly is technology evolving?

important because the appetite for this type of technology is enormous.

Moving down the chain, we also own Northvolt, which could become one of the biggest manufacturers of batteries in Europe. Meanwhile, a holding in ChargePoint, reflects our faith in what could become the biggest electric vehicle-charging network.

Thinking further ahead, we even own some flying car companies. This might have been the realm of science fiction a decade ago, but as battery energy density improves, and costs fall, they are becoming a commercial possibility.

How important is China?

Very. I recently spoke to the CEO of Shopify, a firm that provides the tools for retailers to operate online, about where he looks globally for creativity and new ideas. His reply, “The East Coast of China.”

That is because it is the one place in the world, outside of Silicon Valley, where entrepreneurs invest significant amounts of their own capital in innovative fast-growing private businesses. They have another huge advantage in the sheer scale of their domestic market. For example, as many consumers in China use a smartphone as those in Europe and the US combined. As a result, new products can take off very quickly.

That is why we own Meituan Dianping.

They deliver close to 25 million meals a day in China, compared to, say, Just Eat or US giant Grubhub, where the number is more like 500,000.

The difference is also evident in the underlying infrastructure. Mobile payments, which are ubiquitous in China, make the point well. Whilst we

Moore’s law states that the amount of computing power that you can buy for $1 doubles every 18 months. Extend the timeframe and in ten years’ time $1 will buy close to 100 times the computing power it does now.

If we apply that principle to a firm such as Amazon, it is possible that the technology that powers their shop front will be 100 times more powerful in another decade, a fact that should make conventional retailers very nervous.

In that context, when it comes to the more outlandish technologies, such as the flying cars I just mentioned, investors must view their future growth path through the lens of them deploying 100 times their current processing power and delivering three or four times the energy efficiency they do today in a matter of years. That is why it pays to be open-minded about the best future investing opportunities.

Sebastian Lyon, Founder and Chief Investment Officer at Troy Asset Management

What is your view on inflation?

There is little certainty about where it might go in the medium to long-term, however I think that the pandemic has changed its potential trajectory.

Up until the start of 2020, big deflationary forces around the globe were underpinned by the relentless march of technology, high debt levels and demographics. That triumvirate has presented Central Banks with big headaches when it comes to stimulating growth. After the last financial crisis, they responded by entering a new era of zero interest rates and vast amounts of quantitative easing (QE).

The events of 2020, however, may have been the trigger for an important

FUNDS IN FOCUS

change in direction. Prior to then, the fruits of QE went largely to the banks to shore them up. In the UK, Chancellor George Osborne tightened fiscal policy, whilst allowing monetary policy to remain loose. The net effect was that all the money that was being printed never made it into the real economy, and that created deflation.

More recently, however, we have seen more in the way of “peoples QE” and so investors should now be more alert to inflation. Although we are not about to lose sleep over a short-term oil price spike, for example, we need to consider how the world will look in 2022 and beyond. Most people below the age of about 60 will not be used to living in any sort of inflationary world. As stock pickers, that sort of backdrop would see our focus switch more heavily towards avoiding losers as well as selecting winners, because businesses that are not structured to deal with inflation will come under huge pressure if it re-emerges.

For me, the key signal of a change will be wages growth. Once that starts to lift off, inflation can quickly become embedded in the wider economy. If, on the other hand, it stays subdued then the trio of disinflationary forces I mentioned earlier will probably prevail once more.

How do you determine your asset allocation?

We have always operated four investing “buckets”. Starting with equities, pre-pandemic we lived through a largely uninterrupted bull market from March 2009. As a result, valuations are relatively high. When it comes to wealth preservation, we need to accept that the buying opportunities that were available a decade ago are not there now. That explains why our equity allocation came down to only around 30% pre-pandemic. It spiked a bit as the virus took hold and we increased our exposure to the growth names that we have always liked. In more recent months, however, we have been bolstering our cash reserves following a solid market run up.

Summer 2021 — 17

FUNDS IN FOCUS

Another theme that has influenced our strategy is falling real interest rates, something we have been seeing for the last 20 years. That trend has put fixed income securities under pressure – they cannot protect investors the way they used to because their income has evaporated and so has any opportunity for meaningful capital growth. As such, we prefer to get our bonds exposure via the likes of treasury inflation-protected securities (TIPs) and index-linked bonds.

Savers may note that I do not foresee positive real (inflation-adjusted) interest rates emerging for some time yet.

Elsewhere, we have held some gold for around 15 years as a diversifier. In a world of currency debasement and zero interest rates, it will always have role to play. Since we first bought it in 20042005, the price has outperformed the broad UK stock market by a reasonable margin in sterling terms.

Our remaining holdings tend to be in liquid assets so that we are ready to take advantage of volatile markets and any short, sharp falls in equities. That said, we only go after stocks that meet our strict criteria. Since we like firms that pay us to own them, rather than those that need to raise capital at the first sign of trouble, we look for strong cash flow and solid balance sheets.

Victoria Stephens, Fund manager and member of the Economic Advantage team at Liontrust Asset Management

What is your view of the UK stock market post-pandemic?

We are enthusiastic about it but nonetheless operate a very strict investment process. We only select businesses that demonstrate at least one of our three key intangible asset strengths; substantial intellectual property (IP), an edge in distribution, and high levels of recurring income.

The technology and healthcare sectors meet our criteria, as do some industrial, engineering and FMCG firms plus a few in the media space. We also like fee-based financial companies, such as wealth managers and those investment platforms 18 — Summer 2021

that can demonstrate a recurring income.

Conversely, we tend to avoid areas of the market where we cannot see much intangible strength, such as retail banking and the materials sector.

As a specific example, the UK is home to some wonderful engineering companies with world-beating IP, such as Renishaw which is a leader in the field of metrology (the science of measuring things). The firm manufactures specialist probes and software for precision measurement so that machines and parts can be calibrated to very high tolerances. Its applications range from neuroscience to manufacturing and the automotive industry.

They are also leaders in ‘additive manufacturing’ or ‘3D metal printing’.

This high-tech process uses machines to create three-dimensional, complex metal parts, building them up layer by layer from powder. This is an exciting, cutting edge, production technique.

More broadly, I am a big fan of UK technology in general because it is underappreciated by other investors.

Whilst I concede that exciting, large tech firms may be few and far between in the London market, within the smallcap and AIM arena I could pick out 56 software specialists, a number of which have the potential to become tomorrow’s industry leaders.

IMImobile is a case in point. It provides enterprise software solutions which help large firms, such as banks or telecoms companies, to communicate with their own customers. It was recently acquired by the US software giant Cisco, at a considerable premium, as they could clearly also see the potential.

At the other end of the size spectrum, we also hold some FMCG giants whose competitive advantage is built on huge international distribution networks that support household brands. Unilever is one, with its vast array of personal care, food, and homecare products. Reckitt Benckiser is another that spans personal health and hygiene. Diageo is a third, with its premium spirits such as Smirnoff and Johnnie Walker. These Londonlisted firms all offer investors access

from the UK to increasing global wealth and the world’s developing markets.

Are equity market valuations too high?

I do not think so. For starters, the principal source of uncertainty that has been hanging over shares for four-plus years has gone now that a Brexit deal has been signed. Whilst we expect to see a significant period of adjustment to the new normal, the firms we are speaking to have not tumbled over a cliff edge in the way that some commentators predicted. Most of them are looking beyond Brexit, and COVID-19, with a degree of confidence and an intention to invest capital.

Sterling adds to an improving picture.

We have seen a decent recent rally, yet in historic terms the pound is still far below its longer-term average level versus other currencies. In that context, the UK market should remain attractive to overseas investors.

A focus on growth does mean that some of our stocks can look expensive when screened using traditional valuation metrics. Nonetheless, our fund remains at the cheaper end of its spectrum overall, relative to its benchmark. Besides, I am satisfied that the businesses in question can grow faster than the average UK company thanks to some of the competitive strengths I flagged earlier. Our preference for smaller firms, with impressive growth potential, makes the search for this type of holding a lot easier.

Importantly, many of the businesses we like are exposed to multi-year, structural growth themes which should outlast even the biggest cyclical swings. An obvious example, given our focus on intellectual capital, is digitalisation. We gain our exposure to it via specific technology investments, or by holding firms in sectors where it is enabling them to become more efficient, or to grow their suite of products and services. Whatever investment choices we make, they will always reflect a focus on buying into permanent thematic transitions, rather than short-term fads. ●

GUEST INTERVIEW

Britain’s balancing act Vicky Pryce Economist and author At a recent Killik Family Office virtual event, Vicky assessed the impact of the pandemic and Brexit on our economic future.

What is the immediate outlook?

The data suggests that we are in a global recovery phase, at least in the short-term, as economies open up and pandemic restrictions are lifted.

The backdrop for this has been some unexpectedly strong performances from key global markets. The US economy, for example, only shrank by around three percent over the course of a challenging 2020, whilst China managed to generate growth over the same period.

Closer to home, UK manufacturing production has been on an upward trend. Alongside construction, it was able reopen after the first lockdown, through the early part of 2020, and has grown more or less uninterrupted since. This was evidenced by recent data from the CBI Industrial Trends Survey, which was some of the best we have seen in the last few years. Meanwhile, Make UK has doubled its forecast expectation for manufacturing growth for 2021 to 7.8%. As for the services sector, it too is starting to make a significant contribution to growth, having only been able to gradually ease face-toface restrictions.

On the consumer side, retail sales bounced back strongly this spring thanks, in part, to a mini boom in the hospitality sector, triggered by the unleashing of pent-up consumer demand. This is being reflected in staff shortages across businesses ranging from restaurants to bars and theatres,

a trend that will doubtless be reflected in wage data going forward. A property market surge, coming on the back of an extended stamp duty holiday, has helped to further bolster consumer confidence.

In summary, then, the short-term outlook is sunny, albeit problems linger across travel, tourism, hospitality, entertainment and sport as reduced social distancing measures nonetheless continue to impinge on their full re-emergence.

How long will this last?

The key question is to what extent the economic uplift we have seen so far in 2021 can be sustained. Once we look beyond a widely anticipated initial surge, as lockdown savings are released, things are less clear. Whilst we have seen a spectacular recovery in some sectors, others such as airlines, travel firms and entertainment venues, including those catering for the night-time economy, continue to languish. Elsewhere, in the retail sector, we have seen a serious shake-out, with heavy job losses coming on the back of increased automation and consumers substituting online purchases for visits to high street shops. This is at a time when millions of people are still being supported by the State, via measures such as the furlough scheme, albeit on a gradually decreasing basis.

Government policy decisions will therefore continue to play a key role in our longer-term fortunes. I hope that firms will start investing again, spurred on by the super-deductions for tax announced recently by the Treasury, even as they absorb corporation tax rises announced in the same Budget.

The early signs are positive, in so far as we have seen relatively few complaints from businesses so far. Nonetheless, many firms face other bigger challenges, such as increasing costs and a huge debt overhang accumulated in the low interest rate era that preceded the pandemic. Estimates suggest that up to 800,000 smaller UK firms are in severe financial difficulty, with some at risk of going under, even as their larger peers pay back special loans and furlough money.

Consumers with jobs and money to spare, meanwhile, will need to stay confident in the face of tax increases as the impact of the Chancellor’s decision to freeze certain key thresholds starts to bite. A recent FCA report, suggesting that around 3.5m extra people are now under financial duress in 2021, muddies that picture somewhat over the medium term.

Summer 2021 — 19

GUEST INTERVIEW

Are we a more productive nation post-pandemic?

Up to a point, yes. Firms in some sectors seem to have successfully reduced their overheads by, for example, decreasing their reliance on expensive properties. At the same time, they have adopted new practices, such as teleworking. Where they have been able to boost output per worker as a result, without incurring greater wage costs, they will have enjoyed some productivity gains. However, with labour shortages rife, it remains to be seen how long they can hang onto these, which is why I think it is too early to judge whether we have seen a stepup in overall UK productivity.

Further, there is a hidden problem here, and it is one that should concern policy makers. In a bid to cut costs, as things begin to normalise and we see a gradual return to the office, firms may well be tempted to limit the amount of space they provide, and start distinguishing between workers by bringing the workers they need most back to the office (perhaps using a flexible or hybrid model) whilst leaving others at home. The risk, which has already been flagged by the Trades Union Congress (TUC), is that in doing so they create an ‘underclass’ made up of employees who are based remotely, quite likely at home, doing largely commoditised work. Not only are these workers likely to miss out on training, promotions and pay rises, but they may be offered little, or no, compensation for the costs that working at home carries. If these same firms also strip out their more expensive, but also more experienced, middle managers, how will they retain the skills needed to motivate and supervise this sort of complex, hybrid workforce?

So, whilst the shift to more remote working during the pandemic may have prompted people to work harder, the extent to which this effort will translate into lasting productivity gains is not obvious yet.

20 — Summer 2021

How will Britain balance its books?

The first thing to note is that an increase in state debt, no matter how large, is not expected to be paid back in any conventional sense. Indeed, if anything, the stock of debt tends to increase over time, unless the public sector starts to run annual balanced budgets (or even surpluses), as it is rare that revenues in any given year exceed spending. During the period since 1970, Britain’s budget deficits have averaged 3.6% of gross domestic product (GDP) and the last time we ran a surplus was in the financial year 2000-2001. While a persistently high gap between revenues and expenditure would worry markets, large budget deficits themselves tend not to last for long.

The “automatic stabilisers” spring into action as the economy starts to recover, and tax revenues and other receipts subsequently pick up.

Additionally, the planned corporation tax rises in 2023, plus the freezing of income tax thresholds from next year, which were amongst other measures announced by the Chancellor in March, will help. So too will tightening the purse strings for a number of non-central government departments, about which we will hear more in the in the autumn spending review.

Cutting expenditure back more sharply, by imposing austerity measures, like the ones we saw during the decade after the financial crisis, is another way of bringing deficits down and possibly even reducing the stock of debt.

However, the cost to the economy can be significant and persistent. Besides, given the long-term impact of both the pandemic and Brexit, the government will still need to borrow to cover the economy’s needs for years to come and certainly throughout the course of the current parliament. So, whilst a certain amount of tightening may be needed, the best way to get the debt to GDP ratio down from its current level of nearly 100% of GDP is via faster economic growth. Little has been said explicitly so far by the Treasury about areas such as capital gains tax and inheritance tax, where many people expected to see changes. So, it appears that the plan is indeed to rely heavily on growth, coupled with some inflation, to get the UK back to a more stable fiscal footing.

The obvious short-term risk to this scenario is a sharp rise in inflation.

So far, although the year-on-year consumer price index (CPI) has gone up here, at the time of writing it is still only just above the Bank of England’s 2% target. This uptick has been caused by a demand spike colliding with supply constraints, a problem reflected in commodity price jumps for everything from oil to copper and in input costs to manufacturing, for example across semiconductors and construction materials. It is also spilling through to wages, despite a relatively high rate of unemployment.

What is more, inflation is becoming a global phenomenon – in the EU it has risen to 2% and in the US to 5%.

Central Banks will no doubt keep a watchful eye on prices going forward, albeit they mostly have little choice but to let the inflationary cat out of the bag to some degree. If they raise interest rates too far or too fast in response, or slow down or reverse their quantitative easing operations too soon, they risk damaging any recovery. They also need to prevent unemployment surging as that could trigger a host of wider societal problems.

GUEST INTERVIEW

As state support, such as the furlough scheme here, is phased out, a big challenge will remain for all advanced economies when it comes to dealing with the many unskilled, and mainly young, people who have lost out during this crisis.

could always exist, though in a slightly more limited way, within the EU structure. We had in fact abolished them ourselves in 2012!

Whilst we were a member state, we also had a powerful impact on the standards and regulations adopted by Europe as a whole and, by extension, internationally. We pushed for the eastward expansion of the EU bloc and opened our doors early to people from some of the later succession countries. For me, therefore, the fact we are the first major country to leave is ironic and adds a layer of economic uncertainty to Britain’s future path.

What impact has Brexit had so far?

In the short-term, it has created an extra set of headaches for policymakers and businesses.

The immediate priority for the government should be negotiating the changes needed to the original Brexit deal to ensure that goods can flow as freely as possible between the UK and Europe. The extra costs now involved for anyone who exports to the EU, or imports from it, are substantial, which is a problem given that we sell 45% of our goods and services there. The non-tariff barriers that have been imposed on the UK across everything from airlines to road hauliers, as well as the extra health and other checks needed at the border, are restricting the movement of goods, increasing costs and dragging down profit margins.

Small and medium-sized enterprises (SMEs) in particular, are voicing their concerns about the difficulties created by this new environment, now that the UK is a third-party country as far as the EU is concerned.

Meanwhile, there has been no agreement with the EU on services, including the all-important financial sector, or around qualifications. The resulting restrictions on the freedom of movement are already creating shortages in many areas of the economy, including construction, hospitality and agriculture.

Admittedly, some of this downside had already been anticipated and on the positive side, a certain amount of uncertainty has now disappeared.

However, I do worry about the longer-term impact. From a structural perspective losing free access to what

was practically a domestic market of 500m people, where economies of scale could be enjoyed, can only be bad news for many businesses even if other trade deals materialise.

Vicky Pryce is a board member of the Centre for Economics and Business Research (CEBR), a former Joint Head of the UK’s Government Economic Service and author of ‘Women vs Capitalism’. ●

That is because the “economic gravity model” suggests it is usually easiest, cheapest and most synergistic to trade with your nearest neighbours.

Free trade deals with the Anglophone countries, including the US and the BRICs, alongside closer links with the Commonwealth or Pacific and South East Asian nations, are unlikely to fully substitute for what are likely to be weaker ties with the EU. Meanwhile, the attraction of the UK as a gateway to Europe for foreign direct investment has been inevitably reduced.

The benefits of being outside the EU also confer little extra advantage in terms of policy flexibility. After all, we were always able to initiate state aid programmes as an EU member, for example, and yet we spent less on state aid whilst we were within it than, say, Germany and France. Meanwhile, the concept of “Freeports”, eight of which were announced to great fanfare by the Chancellor recently,

For a copy of Vicky’s latest book, please go to hurstpublishers.com/ book/women-vs-capitalism/ and apply the code WVC1411 to obtain a 25% discount as a Killik client.

A short article, featuring some of the key themes from it, will appear in the next issue of Confidant in the Autumn.

Summer 2021 — 21

S P E C I A L S I T U AT I O N S

Uncovering value Peter Bate Portfolio Manager Peter highlights three stocks that he believes are underappreciated by the wider market. Please note that these are not covered by Killik & Co research.

pricing on behalf of the former, whilst ensuring that the technical specifications of the bricks required on each site are met with deliveries that match production schedules.

In the Special Situations team, we are very much bottom-up stock pickers who assess firms on their own merits.

As such, we do not solely focus on either a pure growth strategy or a solely value-based one. That’s because, whilst a pure value mindset has generated good results over the long-term, it has nonetheless also suffered significant periods of underperformance. The most obvious were during the technology boom of the late 1990’s and more recently during the decade running up to and encompassing the pandemic.

Nonetheless, this quarter I want to highlight three stocks names which could benefit from some big, and hopefully near-term, catalysts which will unlock hidden value.

However, bricks are not the whole picture. The firm has also leveraged its relationships with housebuilders to offer them a one-stop shop for a broad range of building products. Indeed, the primary reason for the group listing on AIM in 2019 was to drive this model forward via acquisition. So far, it has completed ten in the last three years, despite the obvious challenges thrown up by a pandemic.

Brickability – building profits Brickability is a specialist distributor of building products used by housebuilders and contractors in the UK. However, its origin lies in bricks, where it acts as a “brick factor” – in effect, as an agent with deep product knowledge.

Bricks are esoteric when it comes to their manufacture and supply due to the high capital costs of creating brickworks, coupled with the need to run such facilities continuously.

In the wake of the 2008 recession, significant reductions in the field sales forces of UK brick makers, combined with large cutbacks within the purchasing departments of housebuilders, created Brickability’s opportunity. The firm can optimise 22 — Summer 2021

We recently invested in Brickability as part of its capital raising exercise to part-fund the sizeable acquisition of Taylor Maxwell, another supplier to the housebuilding sector. The company raised a total of £55m in new equity to fund the £63m enterprise value (EV) takeover, which equates to a maximum historic EV to earnings before interest, tax, depreciation and amortisation (EBITDA) multiple of 5.4.

Taylor Maxwell operates a similar business model, albeit it has a greater focus on timber-based products that are sold using a lower margin “pass through” structure. Crucially, the two firms have less than a 10% customer overlap, meaning there is significant cross-selling potential, given that Taylor Maxwell has strong relationships with several second-tier house builders.

Further, with its higher overhead burden, synergy benefits should materialise that are not fully reflected in market forecasts, before functional duplication is factored in. Even without these, the deal is expected to boost earnings by at least 25% during the financial year 2022 (FY22).

At the issue price of 95p, the shares trade on 13.4 times March 2022 earnings (based on a nine- month contribution from Taylor Maxwell), falling to 10.8 times for 2023, the first full year of ownership. Meanwhile, the prospective yield is 2%.

As for peers, we would include 11 firms within the UK building materials space; Breedon, Genuit, Grafton, Howdens Joinery, Kingspan, Marshalls, Norcros, SigmaRoc, Travis Perkins, Volution and Wickes. This group has a surprisingly tight valuation range, with a current year average price to earnings ratio of 21.3 (median 22.3), and an average of 18.7 (median 18.3) for FY22. We believe that this acquisition will act as a catalyst to close the valuation gap as the business proves its “buy and build” model and its increasing size makes it more attractive to institutional investors.

Sureserve – energising growth Sureserve is a leading regulatory compliance and energy services group that performs critical functions for homes as well as public and commercial buildings. With a focus on clients in the UK public sector and regulated markets, its services are delivered through two divisions. During FY20 compliance activity generated 69% of revenue and 94% of profits and energy services the rest. However, given that the latter’s activities were restricted by the pandemic, we would expect its profit contribution to be more like 35% by FY22.

The key business line at the Compliance Division is the annual inspection and testing of gas appliances in the social housing, public buildings and educational property sectors across the UK. As the largest provider of public sector gas testing in

S P E C I A L S I T U AT I O N S

the country, a 15% market share reflects the fragmented nature of this market.

The work it performs is nevertheless safety-critical, non-discretionary and generally delivered under multi-year contracts of varying lengths, a fact reflected in the firm’s £372m multi-year order book. Further, customers, which include local governments and housing authorities, usually agree to inflationlinked pricing.

Whilst the growth potential for the underlying market is limited, we nonetheless see revenue gains arising as Sureserve takes more of the available market. In a highly regulated area such as this, failures can be catastrophic, which should play to the firm’s reputation as a large, high-quality operation. Recent investment in the bidding team has reportedly already driven an improvement in the conversion ratio of bids to wins from one in three to one in two. A fragmented market also offers scope for non-organic growth, an opportunity that was flagged in the recent interims.

Overall, EBITA margins at the division have grown strongly via a combination of revenue growth, a richer mix of projects, and efficiency improvements.

However, our investment case does not rely on additional margin expansion.

Instead, the crux of it is the valuation of just 10.3 times September 2022 earnings, alongside a 7.0% free cash flow yield and 2.6% dividend yield.

This is compelling on an absolute basis, given the high levels of earnings visibility (around 99% for FY21, 56% for FY22 and 26% for FY23), the scope for growth from acquisitions, and a potential recovery in the Energy Services business.

By comparison, its nearest listed peer, Marlowe, trades on about 29 times 2022 earnings, albeit it has adopted a different strategy based on “buy and build”. Even so, successful M&A execution from Sureserve will make it harder to justify the valuation gap.

The balance sheet is also strong, with net cash of £9.7m reported at the

interim stage in March 2021. This should build towards a year-end position of closer to £12m, rising to £18m by the end of FY22. At these levels, special dividends should be on the cards in the absence of suitable M&A.

Studio Retail – scaling sales Studio Retail (formerly Findel) is a digital value retailer with an integrated financial services proposition. We believe that it operates in something of a retail sweet spot and therefore view its target of £1bn in annual revenue, from around three million customers, as conservative.

Historically, the operational picture has been clouded by the sheer number of businesses within the group, encompassing healthcare, door-todoor product sales, a dedicated online sports retailer and even education.

However, management have disposed of all of these, leaving the firm as a pure-play online retailer generating over 90% of sales via its “digital department store”. The rest come from a small base of customers who still submit orders via the phone or by post. Interestingly, the company still uses catalogues as part of its overall marketing mix, where it deems them to be more cost effective than online advertising.

Although there is stiff competition from “digital first” retailers (e.g. Amazon, Shop Direct and N Brown), traditional value retailers (Primark, B&M, ASDA/ George and Argos) and credit providers (Argos, Next, Shop Direct and N Brown), none of them quite captures its home market in the same way as Studio Retail.

Around 2.5million active customers buy from it via the internet and are offered cash payment terms, or a range of credit options, which are taken up by about 60% of them.

In common with other online retailers, the closure of physical stores as COVID-19 raged helped to drive record sales and profits for the group in FY21, with revenues up by 45% and profit before tax by 75%. Arguably more important still has been the 36% expansion of the overall customer base,

with around 15% of that coming from the firm’s more loyal credit customers over the last year. We hope that this will lay the foundations for several years of further growth.

The company has nonetheless been in something of a no-man’s land over the last 18 months, when it comes to an earnings consensus. This is down to several factors. Firstly, it was under offer (at 161p) for a period from the Frasers Group, which still retains a 27% stake. Next, a strategic review was being finalised which culminated in the eventual sale of its education business. And thirdly, the initial shock of the pandemic resulted in analysts pulling forecasts.

At the time of writing, the shares trade on 7.4 times March 2022 earnings. This is based on conservative forecasts which imply around a 10% decline in revenue in FY22 versus FY21. Our view is that the channel shifts that have occurred in the wake of the pandemic will prove more permanent, and the group will benefit from a material increase in customers recruited during the past year. That makes the current rating seem deeply depressed when set against the average 12-month forward price to earnings (P/E) ratio for the wider FTSE All Share retail peer group of 17.4 (excluding loss making firms) and the equivalent multiple of 25 for FTSE AIM retailers.

Although we acknowledge that the firm’s financial services exposure will hold back the rating, we see several positives. These include, a streamlined operating structure combined with balance sheet net cash (excluding the securitisation facility used to enable the credit product), a resumption of market forecasts and, more recently, a reduction in the Frasers Group stake from 36% to nearer 27%, with any additional sell down likely to be good for free float and therefore the share price.

As such, we think that the discount, at the time of writing, of around 50% can no longer be justified. ● Summer 2021 — 23

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