Confidant Spring Issue 2020

Acting for clients as they would want to act for themselves

Spring issue 2020 Published quarterly

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

Supporting private investors

Climbing the ladder

Pushing on through

Growing it alone

Paul Killik’s wishlist of changes, p4

Svenja Keller on helping young professionals, p12

Peter Bate’s crisis-resistant stocks, p18

An interview with Mark Furness, p20

Navigating rapid markets How to position portfolios, p10

C O N TA C T S

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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estimate contained herein changes or subsequently becomes inaccurate, or if research coverage on the subject company is withdrawn.

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PERSONAL VIEW

FROM THE EDITOR

Learning from adversity Tim Bennett Head of Education My birth year, 1967, made me a child of the 1970’s. To paint a brief snapshot for any readers who are too young to remember that decade, I was raised to the sounds of Queen, Fleetwood Mac, Pink Floyd and Stevie Wonder. Back then, home computing was almost non-existent – in our house we had to wait until Sir Clive Sinclair launched his wash-wipe plastic ZX-80 and 81 in those respective years.

Meanwhile, Dad went through several variants of the Morris Marina Estate during our childhood. I suspect that was not because he loved changing cars, but rather that he had little choice given the build quality. Just reading those snippets, you might conclude that this was a world removed from 2020. However, the arrival of coronavirus, with all the ensuing mayhem it has wrought across lives, businesses and financial markets, has caused me to ponder whether that distant decade could nonetheless teach us a couple of useful lessons.

The first relates to investing. Anyone who lived through the bear market of the early 1970’s may recall that UK stocks lost, in aggregate, around two-thirds of their

value between 1971 and 1974. The decline was so steep that I wouldn’t be surprised if it frightened a generation of long-term savers away from equities for good. What a pity that would have been. Why? Because, as we now know, with the benefit of that wonderful thing we never have at the time called hindsight, the market not only recovered several years later but it went on to scale new highs, albeit not without some sharp spells of subsequent volatility.

My conclusion is that, although what has happened to stock markets in recent weeks may feel uniquely awful, history will likely look back on it with a similar degree of detachment. That’s because unless one sharp downturn has the power to destroy your faith in human ingenuity and our ability to progress economically and financially over the long-term, quiet optimism remains the best emotional bet for investors.

My second lesson from the 1970s relates to the way we view the family unit. When I was growing up, my father would insist that the five of us (including my mother and my two younger siblings) spent Sundays together. For a whole day we

C OMING UP

Thinking ahead p6 Absolute returns p9 Spring drinking p16 Bond breakdown p22 Market update p23

didn’t worry about the outside world, a feat made easier by the absence of mobile devices of any sort and the presence of a television that only offered a handful of channels by way of distraction. At this time of year, we just talked, played, chatted and ate lunch. Fast forward to today and it sometimes seems as though the only way this bonding ritual comes about is when people are asked to “self-isolate”. To many, this rather grand-sounding stipulation from the authorities has felt like an imposition. However, I hope that if one good thing comes out of this coronavirus episode it is that people reconsider the value of their families. A crisis like this one should throw into sharp relief the fact that living in a global economy, with all the independence and opportunity it creates, does not really make us any less dependent on each other when it comes to the crunch.

Indeed, in an era when old-style final salary pensions are disappearing, the cost of everything from education to care is rising and State support is on the wane, the strength and support of the family unit, both within and across generations, is arguably more important than ever. ●

SECURITIES IN THIS ISSUE Polar Capital Heath Care Fund p8, CG Absolute Return p9, Keynes Systematic Absolute Return p9, BH Global p9, Personal Assets Trust p9, MJ Hudson p18, Accrol p18, Boku p19, Aquis p19, essensys p20 Please note that the securities relevant to our cover article on pages 10 & 11 can be requested via your Adviser.

Spring 2020 — 3

PERSONAL VIEW

Righting regulation for UK investors Paul Killik Senior Partner This quarter, Paul urges investors to try to look beyond the immediate crisis and highlights some of the main changes he would like to see implemented by regulators for the benefit of clients.

The recent economic and stock market upheaval, triggered by the outbreak of the coronavirus, has at times felt allconsuming. Yet, we will emerge from this crisis, just as we have previous ones.

When we do, the first concern that I raise this quarter below (“reining in passives”) needs to be addressed globally as we all start planning for a more positive and less volatile future.

Meanwhile, although we are currently in transition, having left the EU on 31st January, we should not forget that we continue to operate under EU rules in 2020. We must not lose sight of the importance of this period when it comes to the changes that we should be seeking as soon as we are able to write our own.

That’s why the second half of my article is part of an extensive shopping list of issues and solutions that I wish to put before Government, Regulators and other interested parties and which I would like to share with you.

Reining in passives In my personal message in March, which I would like to return to parts of here, I quoted Roosevelt’s famous phrase that, “the only thing that we have to fear is fear itself ”. I noted then that there was more logic behind the steep market falls 4 — Spring 2020

surrounding the Global Financial Crisis in 2007/09, when the global banking system was on the point of collapse, or the boom and bust of 2001/03, when all technology companies were significantly overvalued, than there is for the more dramatic declines we have seen during the first quarter of this year. These, as we all know all too well by now, have been event-driven and centred on a pandemic. But whilst we all accept and understand that the coronavirus outbreak will pass, no-one can deny the huge toll it has extracted in terms of loss of life and short-term economic disruption. However, and without wishing to minimise the human cost, I would like to reiterate the point I made in March that economically this is likely to be collateral, rather than structural, damage. I would also like to take this opportunity in Confidant to highlight again one of the key culprits behind the precipitous and rapid declines that have characterised markets in recent months – passive products.

Since 2009, we have seen an explosion of indexed or passive investment vehicles of one sort or another, championed in pure growth terms by the exchange traded fund (ETF). These essentially represent computers taking over stock market investment. So much so that, at the time of writing, this style of automated investing represents around half of the US stock market by value.

The essence of passive investing is that it is quantitative rather than qualitative, by which I mean that the selection of securities for a given portfolio is determined solely by reference to their inclusion in a predetermined group, such as an index. This means that securities are not selected by reference to their relative quality, an approach which is otherwise known as active investing.

An army of passive products was allowed to evolve as investors sought ways to match the performance of an index.

These indices were considered to be a reliable benchmark on the grounds that it is difficult to criticise performance that is more or less in line with such a benchmark. This approach has become known colloquially as “meeting, rather than beating, the market”. The result is a portfolio of investments held in a passive portfolio that attempts to mirror the benchmark against which it is measured.

The big downside to this seemingly simple arrangement has become all too clear recently. A passive investment vehicle is designed to mimic the “herd instinct” that makes investors prone to follow one another, sometimes blindly.

Rational though we like to assume we are, the reality is that humans are just as susceptible as wild animals are to a stampede, driven by an unknown fear.

I hardly need to say that we have seen plenty of that in recent months.

ERSONAL VIEW P

Active investing, on the other hand, is underpinned by expert analysis based on the comparison of one business to another.

This process tends to mean that securities are selected on their qualitative merits.

This subjective approach to investing leads to multiple different portfolios. The reason this matters in a bear market scenario is because it is much less likely to lead to everyone selling an exact replicator of a small number of indices or portfolios, the result of which is an automated avalanche that can overwhelm the market. I therefore sincerely hope that this episode will convince regulators globally that they need to better control, or phase out altogether, this style of passive investing, now that the resulting level of unconstrained volatility is plain for all to see.

Next, I turn to the specific regulatory concerns that I would like to see addressed as we transition away from Brussels.

Levelling up VAT High up this list is the VAT on fund management charges that firms such as ours are obliged to charge for managing a portfolio of clients’ assets on a discretionary basis.

It has always struck me as unfair that an investor’s personal portfolio of investments, managed upon their behalf, attracts VAT whereas the AMC (Annual Management Charge) of any authorised fund, whether open or closed-ended, is exempt from this tax. The problem is that the VAT rules are closely governed by Brussels who seem to be in thrall to product (i.e. fund) manufacturers. The argument has always been that direct investments in equities and bonds are too risky for private investors, who should therefore be encouraged to buy typically unitised products instead.

However, my view is that we live in a competitive world where, quite understandably, investors are increasingly focusing on the costs associated with managing their investments and the effect that these have on the overall return that they receive. In that context, a VAT levy of 20% on an annual charge of, say, 1% is highly material. I further note that the Independent Financial Adviser (IFA) community appears to enjoy an effective VAT exemption, when researching, advising and managing a portfolio, provided they are investing in products. Given that from 1st January 2021 we can write our own VAT rules, I feel that we should take the opportunity to create a level playing field across the financial services industry.

Managing panic Next on my list is the complete abolition of the now all too familiar “10% down rule” letters. Our Managed clients will be well aware of these, having received a spate of them. As a reminder, we must send these out under the current regulations at the point that a portfolio has fallen by 10% since the last periodic valuation and as every subsequent 10% drop occurs thereafter.

To date, nobody has been able to explain to me the sense or logic behind this rule, which merely serves to create more fear in the minds of already anxious retail investors. One of our most important duties as financial advisers is to try to help clients overcome their natural urge to panic in rapidly falling markets. Yet, as one client is reputed to have said “if you want me to stop panicking then stop sending me these letters”. Whilst it is encouraging that the FCA has granted firms a temporary suspension in 2020, this self-evidently crazy requirement serves no public purpose and should be fully withdrawn at the earliest opportunity.

Removing retail roadblocks For my final concern in a wider shopping list I turn to the various iterations of the Prospectus Directive (PD), which have largely served to make life increasingly difficult for retail investors. Prior to the introduction of the first one, nearly 20 years ago, a company seeking to raise money only had to issue a single prospectus that did not discriminate between the different types of investor. However, Brussels unilaterally decided that retail investors were in fact not able to understand such a document and that there should therefore be two types – one for institutional investors and another for retail. Needless to say, very few issuers of securities wanted to go to the expense of re-writing their prospectus in simpler language and consequently, retail investors have been largely excluded from the primary markets.

The absurdity of this situation, to me, is that whilst retail investors can be left out of new issues in this way, they cannot be prevented from participating in the secondary market, at least for equities. In other words, when it comes to, say, new equities they are not allowed to purchase them on day one, at the issue price, but they can subsequently buy from short term institutional traders taking a turn on day two, at which point they are likely to be trading at a premium.

As a further twist to this sorry tale, the bureaucrats decided some time ago that retail investors do not really understand bonds. So, to prevent them buying these securities when they are issued under an institutional prospectus, they require that such bonds can only be traded in multiples of 100,000 euros or pounds in the secondary market, which prevents retail access. This very clumsy rule has been very effective at driving retail investors into bond funds, even though regulators are aware of the systemic issues that can arise for these vehicles when secondary market liquidity dries up.

This is a pity because, in my considerable experience, retail investors understand quite well the simple principle of a dated bond, bought at issue, which they are generally content to hold until such time as it is redeemed.

I therefore think it is high time we reverted to a single unitary prospectus, that does not differentiate between retail and institutional investors, for all new issues. Furthermore, I would also like to see a sterling debt market develop that is accessible to all.

Rounding up I will conclude by wishing all our clients well in what has become a more challenging economic and financial climate in 2020. Please do not hesitate to contact your Adviser if you would like to discuss the issues I have raised in this article or how to best position and protect yourself and your family. ● Spring 2020 — 5

THE BIG PICTURE

Skirting the precipice Patrick Gordon Head of Research Patrick assesses the drastic measures taken during the last quarter to curb the economic impact of COVID-19 and looks at the expanding role of policymakers in trying to manage financial stress.

Assessing the damage Whilst it is commonly acknowledged that the cause of the next major downturn is unlikely to be the same as the last, few people (if any) would have predicted that it would be a global pandemic that would put an end to the longest economic expansion on record. Whilst necessary, the measures taken so far to stop the spread of the virus have had huge economic consequences.

Their impact has been widespread with certain parts of the economy having already been hit very hard by the ‘social distancing’ and ‘lockdown’ measures that are being enforced globally. Service industries, such as travel, leisure and a big chunk of retail, that rely on footfall and freedom of movement, have been hit particularly hard.

There will undoubtedly be casualties as some companies will not be able to survive the steep downturn in their revenues. This will be a particular risk for those firms with a high fixed cost base (“operating leverage” – see box) or with large amounts of debt on their balance sheets (“financial leverage”).

Whilst their profits may have been enhanced in times of growing revenues their profit declines will be amplified by falling sales. In this difficult environment, other firms that are less exposed could nonetheless see a significant disruption to their current business models and face longer-term consequences if they fail to adapt.

It is not all doom and gloom, however.

As Nicolas Ziegelasch notes in more detail on pages 10 and 11 of this issue, some companies should benefit over the longer-term from the fallout and structural changes that may result from this crisis.

Certain brands will even emerge in a stronger competitive position, where excess capacity has been removed, or where they fill a need that may not previously have been fully appreciated. We can expect to see faster growth in e-commerce, for example, 6 — Spring 2020

and for firms that offer essential services to home workers. Furthermore, with the rapid spread of the coronavirus exposing some of the pitfalls of globalisation, following a period where protectionist policies had already come to the fore (witness the US-China trade dispute), local companies could benefit at the expense of those that have previously profited from widespread outsourcing by the multinational giants.

Entering uncharted territory Another key change resulting from the economic fallout is the new level of policy action being led by governments and central banks around the world.

Unprecedented attempts have been made to calm financial markets and support the real economy. As a result, both monetary and fiscal policymakers have entered uncharted territory. At the time of writing, central banks around the world have responded by cutting interest rates aggressively. Some, meanwhile, have enacted a range of other support measures.

The US Federal Reserve, for example, has pumped huge amounts of liquidity into the financial system. It has committed to buying potentially unlimited amounts of Treasuries and agency mortgage-backed securities whilst launching new facilities that will see it purchase corporate bonds to support new issuance and provide liquidity for corporate bonds already outstanding.

While policy responses such as this have helped to ease the tightening financial conditions and strains in the credit markets, it became clear early on in this crisis that a monetary approach alone would not be enough when it came to dealing with the economic fallout. Governments have quickly realised that they will need to become more involved by also providing fiscal support.

Supporting employment Given the huge part that consumption plays in the economic output of many developed economies, including the US and the UK, policymakers know that a huge spike in unemployment would represent a serious threat to the economy and its prospects for a quick post-virus recovery. That is why measures that provide support for companies, to enable them to keep workers in employment, have been included in fiscal packages alongside other measures such as loans to small and medium-sized businesses, mortgage holidays, and certain tax measures.

What is operating leverage?

This phrase describes the relationship between a firm’s fixed costs (typically salaried staff and property) and its total costs, including those that are variable, such as raw materials and part-time staff wages. The reason it matters is that if a company carries high levels of fixed costs it will enjoy super profits when revenue climbs, but it may also suffer rapid falls in profitability if sales fall suddenly.

To illustrate why, imagine a firm makes £100 of sales, has fixed costs of £80 and variable costs of £10.

Profit is £10 (£100-£80-£10). This is a firm with high operational gearing as fixed costs are 89% of total costs (£80/90). Now let’s assume that sales fall by 10% to £90. If we assume that variable costs will also fall 10% to £9 and fixed costs won’t change, profits are now £1 (£90-£80-£9). So, a 10% fall in sales has resulted in a 90% fall in profits.

Sectors that tend to have this sort of cost structure include airlines and certain manufacturing firms. When revenues fall, they are often forced to take aggressive steps to cut costs. Firms with lower levels of operational gearing, on the other hand, may weather a downturn in better shape.

THE BIG PICTURE

Bursting buybacks When it came to corporate funding and structure, one specific area that has come under increased scrutiny, as the current crisis has unfolded, is share buybacks.

This mechanism was one of the key drivers behind a strong equity market performance during the decade-long bull market that followed the financial crisis (Chart 1). The constituents of the US S&P 500 Index combined spent hundreds of billions of dollars a year on buying back their stock.

S&P 500 Buyback Index

S&P 500 Index

450 400 350 300 250 200 150 100

Apr 19

Source: Bloomberg

Apr 18

0

Apr 17

50 Apr 16

The challenge will be financing these massive fiscal measures at a time of falling tax revenues. With government bond yields so low, now is arguably not a bad time for governments to raise funds through the issuance of long maturity bonds. However, there is also increasing talk of other unconventional, and somewhat controversial, means of funding government support. These include via central bank money creation, without the need to raise funds through the government bond market or via higher taxes. A danger of this approach is it could be inflationary once the economy returns to operating at full capacity. Furthermore, the increased co-ordination between monetary and fiscal policymakers that we are seeing could pose a longer-term challenge to the independence of the world’s central banks.

Chart 1 – S&P 500 vs S&P 500 Buyback Index

Apr 15

Crises tend to bring about a greater use of the ‘unconventional’ as policymakers look to do ‘whatever it takes’ to mitigate the economic impact. For example, quantitative easing (QE) emerged from the 2008/09 financial crisis as a more widely used unconventional monetary policy tool. Designed to support the economy, it has remained a key part of a central banker’s policy ‘toolbox’ ever since.

Now, consideration is being given on how to send money directly to individuals, a new measure that has not been used to combat previous downturns.

One of the key reasons this happened was that the low interest rates that have persisted since the financial crisis have offered firms little incentive to hold excess cash on their balance sheets. When companies are generating more cash than they can productively deploy, share buybacks can be an effective means of returning it to shareholders. That is because they provide greater flexibility than a commitment to pay a higher dividend, only to have to cut it at a future date. The low interest rate environment also encouraged some firms to issue cheap debt in order to finance the repurchase of more expensive equity.

However, questions are now being asked about the true motivation for some of these buybacks, particularly when the purchases took place at very high equity valuations.

Since a buyback reduces the number of shares outstanding, it can provide a shortterm boost to certain performance metrics, some of which may be used to determine management compensation packages. In tough times such as these, an earnings collapse can quickly expose balance sheet vulnerabilities. Investors should note that management teams that are seen to have foregone financial flexibility by buying back their shares too aggressively and gearing up by taking on more debt in the process, are likely to come under increasing scrutiny as this crisis unfolds. ●

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.

Killik Explains

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

If you would like to watch Tim’s video on share buybacks and some of the pros and cons associated with them, please go to www.killik.com/explains/whatare-share-buybacks/.

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

Spring 2020 — 7

FUND RESEARCH

Fighting back Gordon Smith Head of Fund Research Gordon weighs up the impact of recent events on the healthcare sector and identifies a fund that is relatively well positioned to cope with the long-term consequences.

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Chart 1 – percentage drawdown for MSCI Healthcare Index vs. All Country World Index 0 -10

Surviving short-term

8 — Spring 2020

MSCI All Country World Index (ACWI) MSCI ACWI Health Care Index

Source: Bloomberg

Chart 2 – Relative price to earnings valuation for MSCI Health Care vs. All Country World Index 20 10 0 -10 -20 -30 -40

Source: Bloomberg

2019

2020

2017

2018

2016

2014

2015

2013

2011

-50 2012

From an investment perspective, the health care sector continues to stand apart for its resilience and defensive attributes even in times of severe economic pressure.

Whilst there is a correlation between unemployment in the US and the level of health care insurance cover for non-life threatening conditions, the increasing need for improved medical provision for an ageing population remains a big long-term trend. In that context, life sciences are an important enabler. This is borne out by the global health care sector’s downside participation ratio of just 65% relative to the broader market over the last ten years (Chart 1).

2010

Technology will remain a major catalyst, as illustrated by the determination being shown by governments and health insurers to move away from a volume-based reimbursement system to one built on value delivery and medical outcomes. This has been enabled, in no small part, by the move to digital record keeping for medical treatments. The wider use of tele-health services and the availability of ever-more capable medical devices, that can be used by consumers in their day-to-day lives, have also been key developments.

Separate to COVID-19, a further short-term factor has been dampening valuations in the sector – the uncertainty surrounding the outcome of the upcoming US election. Some big differences in approach have been voiced by the Republican and Democratic nominees, with the more progressive Democrats promoting “Medicare For All”, a single-payer system which, if passed, would potentially disintermediate and fundamentally change large parts of the US care infrastructure. Even before this outbreak, that factor alone caused the sector to trade well below historic averages, both in absolute terms and relative to the broader market (Chart 2).

2009

The severe stresses in evidence at hospitals, in particular, will amplify the need to find ways to improve the efficiency and effectiveness of healthcare provision.

2007

As for the longer-term outcomes, we believe that the coronavirus outbreak will ultimately speed up structural changes that were well underway before the first cases were reported late last year. Differing health care systems around the world will come under greater and more rapid scrutiny.

-60

2008

Looking beyond COVID-19

-40 -50

2005

The all-important health care sector mirrors these potential outcomes.

For example, as care systems refocus on dealing with those most in need of quick treatment, elective surgery for less-urgent procedures is being postponed. This will cause knock-on effects for the companies providing the medical technology, services and facilities that enable them. Conversely, other areas, such as global diagnostic businesses, could provide an invaluable role in tackling the outbreak and are likely to be in high short-term demand.

-20 -30

2006

At the time of writing, the full impact and longevity of the COVID-19 pandemic remains highly uncertain, with new cases on an upward trajectory across Europe and the Americas. Huge constraints on daily life have been combined with equally large fiscal and monetary policy measures designed to help contain the outbreak and support the global economy. Amidst a lot of resulting uncertainty, one thing is already clear – the scale of the problems being faced by individuals and firms will trigger permanent long-term changes to consumer behaviour and many business models. But whilst areas such as leisure and tourism will be acutely impacted from any prolonged period of enforced social isolation, others will escape relatively unscathed and could even be strengthened.

PERSONAL VIEW

Absolute Return

Absolute Return

CG Absolute Return

PGIM QMA Keynes Systematic Absolute Return

Fund Type

Irish UCITS OEIC

Fund Type

Irish UCITS OEIC

Manager

CG Asset Management

Manager

QMA Wadwani

Fund Size

£297m

Fund Size

£82m

Ongoing Charges

0.45%

Ongoing Charges

0.94%

Historic Yield

1.5%

Historic Yield

n/a

The CG Absolute Return Fund aims to achieve long term capital growth, in absolute terms, by investing globally across a spread of asset classes. Capital preservation is at the heart of the strategy, which entered the recent period of market stress with a notable weighting (>30%) to US Treasury Inflation-Protected Security (TIPS). These have successfully provided useful downside protection during a period of pronounced market weakness.

Risk Rating: 4

The Keynes Systematic Absolute Return Fund aims for an attractive return on capital while attempting to limit the risk of a loss. The team uses a range of systematic strategies designed to capture risk premia in the major traditional asset classes.

Furthermore, it can invest both long and short.

The fund has successfully negotiated periods of changeable market environments since launch by deploying rigorous risk management techniques designed to protect the portfolio from downside.

Risk Rating: 6

Total Return (since inception, indexed)

Total Return (since inception, indexed)

140 130 120 110 100 90 80

Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Oct-18 Jan-19 Apr-19 Jul-19 Oct-19 Jan-20

Nov-19

May-19

Nov-18

Nov-17

May-18

140 130 120 110 100 90 80

Growth

Absolute Return

Polar Capital Healthcare Opportunities

BH Global (BHGG-LON)

Fund Type

Dublin UCITS OEIC

Fund Type

London-listed Inv Co

Fund Type

London-listed Inv Trust

Managers

Gareth Powell, Daniel Mahony

Manager

Brevan Howard CM LP

Manager

Troy Asset Management

Market Capitalisation

£315m

Market Capitalisation

£1,096m

Ongoing Charges

2.80%

Ongoing Charges

0.86%

Historic Yield

n/a

Historic Yield

0.9%

Fund Size

£1.0bn

Ongoing Charges

1.21%

Historic Yield

0.0%

Growth Personal Assets Trust (PNL-LON)

To find out more, please speak to your Adviser. ●

Oct-19

Mar-20

Jul-18

May-19

Share Price

Dec-18

Feb-18

Apr-17

Sep-17

Jan-16

Jun-16

Jul-18

Mar-15 NAV

Nov-16

Share Price

Aug-15

NAV

Oct-19

2020

Mar-20

2019

May-19

2018

Dec-18

2017

Feb-18

2016

Apr-17

140 130 120 110 100 90

Sep-17

140 130 120 110 100 90 80 Nov-16

NAV Total Return (last five years, indexed)

Jan-16

NAV Total Return (last five years, indexed)

Jun-16

NAV Total Return (last five years, indexed)

Mar-15

Personal Assets Trust is a self-managed investment trust managed whose primary objective is to protect the value of shareholders’ funds over the long-term (with secondary aim of increasing it). Reflecting management’s views on the fact that an extended phase of the bull market cycle had created inflated asset prices, the fund started the year positioned defensively, with prominent allocations to assets that can provide protection from inflation, such as index-linked government bonds and gold. Risk Rating: 4

Aug-15

This fund aims to preserve capital and achieve long-term growth by investing in a globally diversified portfolio of healthcare companies.

The fund seeks to outperform the MSCI ACWI Healthcare Index and the team believe that a concentrated portfolio of high conviction ideas (40-45 holdings) is the best way of delivering superior risk-adjusted returns compared to the Index. Risk Rating: 6

BH Global is a London-listed, closed-ended investment company managed by Brevan Howard, a hedge fund manager, led by Alan Howard. It seeks to generate strong riskadjusted returns in all market conditions by giving investors a broad-based exposure predominantly to macro trading strategies across multiple asset classes. This strategy has a strong track record of providing diversification and ballast within portfolio during times of market stress. Risk Rating: 5

170 160 150 140 130 120 110 100 90 80 2015

Given the significant volatility in markets over the early months of 2020 we highlight some of the funds that aim to provide defensive properties to portfolios.

Our Alternative Allocation Service invests in a range of strategies such as these, alongside other assets that fall outside traditional equity and fixed income securities, including property and infrastructure. The service aims to blend differing investment approaches and styles to maximise the diversification benefits within portfolios. Please speak to your Adviser to find out more.

May-17

That is why this quarter I want to highlight the Polar Capital Healthcare Opportunities Fund. An experienced team has the flexibility to invest globally and right across the health care sector in order to target long-term capital growth. The resulting portfolio does look rather different to the benchmark index. However, that reflects a belief that the healthcare industry has embarked on a period of major structural change which will continue to generate a wide dispersion of returns between the different sub-sectors and business models within this space.

Key fund data and charts

Nov-16

We believe that an investment in healthcare should be an integral component of long-term portfolios.

With some significant structural change underway, we look for fund strategies focused on companies that fall into two broad camps. Firstly, those driving innovation, such as businesses that are creating new markets or changing medical practices. Secondly, firms that recognise the changing dynamics within the industry and are transforming accordingly, for example by exploiting the use of data and analytics to improve efficiency and medical outcomes.

May-16

Picking Polar

FUND RESEARCH

All chart data source: Bloomberg. Chart data to 2nd April 2020. For details of the Killik & Co risk rating system, please refer to page 7.

Spring 2020 — 9

EQUITY RESEARCH

Planning a post-virus portfolio Nicolas Ziegelasch Head of Equity Research Nic looks at how the COVID-19 pandemic is reshaping the world of equity investing and identifies some of the sectors that are likely to emerge both as long-term winners and losers.

For a full copy of the thematic note that was sent out recently, containing the stock ideas that flow from the five key themes he discusses below, please contact your Adviser A changed world While there is still significant uncertainty surrounding the severity and duration of the coronavirus (COVID-19) pandemic, there is one thing we are sure of: once this virus has been conquered, the economic and investing landscape will be very different to the way it looked just a few months ago. Amongst other things, the crisis has exposed flaws in what were once considered cast-iron global supply chains and thrown into sharp relief the real cost of industrial pollution. It has also brutally exposed inadequate healthcare infrastructure, outdated working practices and fragile retail ecosystems across even the most developed economies. Businesses and governments are already recognising that much needs to change as unprecedented steps are taken to try to stabilise entire economies and the financial systems that are an integral part of them (see also pages 6 and 7). From an investment perspective, this unique period will throw out many winners as well as losers, albeit it may take some time before all of them are clearly identifiable. So, in that context, how should investors frame the way they see investing? We believe that, as a result of COVID-19, we will see an acceleration of five key themes. These should inform your portfolio positioning for the foreseeable future.

Deglobalisation Globalisation has been one of the driving forces of world growth over the past few decades and has lifted hundreds of millions of people, across multiple countries, out of poverty.

It has enabled significant specialisation 10 — Spring 2020

and scale advantages to be captured and passed on to consumers in the form of lower prices and to shareholders in the form of higher sales and profit margins. But now we think that globalisation has not just peaked but it may begin to go into reverse.

Even before this virus struck, global trade faced a massive headwind in the form of the US trade war and the associated import and export bans aimed primarily, but not exclusively, at China. Then came the coronavirus pandemic, which has brutally exposed two issues – the risk of having supply chains concentrated in a single region and an overreliance on being able to source critical goods, including healthcare and food, outside of a country’s domestic market.

As a result, we expect to see economies start to really focus on shifting their supply chains closer to their main markets, with the associated wage differential (onshore labour being usually more expensive than offshore) being addressed through a shift to more automated production. We think that the potential increases in cost that will result from this shift should be mitigated, over the longer term, by lower transportation costs, faster times to market and the ability to offer greater product customisation.

Winners and losers We expect the winners to be providers of automation equipment and industrial software plus developed market industrial property owners. We see the losers being the global shipping sector, contract manufacturing and emerging markets.

Decarbonisation Whilst a direct link in terms of causation has yet to be established, some analysts have drawn attention to the fact that the regions that have tended to see the highest incidence of the virus, including Wuhan in China and Lombardy in Italy, suffer from elevated levels of air pollution. Looking through medical journals, we too have come across work that has found evidence of a link between pollutant exposure and the emergence of infectious diseases in general.

There is also evidence that those living in highly polluted areas are more susceptible to a variety of health conditions, especially of a respiratory nature, that also make the risk of being severely affected by a virus of this type significantly greater.

As a result we think that, whilst large scale capital projects will inevitably slow in the short-term, one lasting impact of the coronavirus outbreak is likely to be an even bigger political emphasis on air quality and speeding up the decarbonisation of the global energy supply. In addition, once the immediate effects of the virus have been dealt with, we expect to see tighter regulation around emissions, both at an industrial level and at a local level, with potentially more cities banning polluting vehicles and driving a quicker shift to electric ones.

EQUITY RESEARCH

Winners and losers We believe that the winners from this renewed momentum will be the whole field of renewable energy generation, grid network operators, electricity infrastructure suppliers, electric vehicle manufacturers and “energy as a service” providers. On the other hand, we see longterm losers in the oil and coal industries and potentially other heavy polluters, most of which could face a significant increase in regulation and therefore operating costs.

Healthcare This crisis has unquestionably exposed the poor state of healthcare infrastructure in many countries, including the UK. For instance, according to OECD data, Britain has just two hospital beds per 1,000 people, compared to six in Germany. Measured as critical care beds, those numbers become just under 7 per 100,000 of population here versus almost 30 in Germany. The UK also has significantly fewer ventilators – the 12,500 (at the time of writing) spread across the NHS, private hospitals and the military compares to 160,000 in the US, which must cater to a population only five times larger. Many European countries have been caught in a similarly dire state of unreadiness, with firms in sectors as diverse as car manufacturing and engineering systems being asked to support short-term production.

We therefore believe that we will see a post-coronavirus reassessment of healthcare systems around the world and this will drive spending on new infrastructure that will enable countries to be better prepared in the future (see also pages 8 and 9). The days of having a healthcare system designed to operate at high capacity for maximum efficiency are therefore very much numbered. We also believe that the world will move towards a next-generation healthcare system, where most of the traditional faceto-face interactions will be removed (for example with GPs here) and replaced with online doctors and artificial intelligence.

Healthcare will also increasingly be decentralised, with more of the routine diagnostics and monitoring taking place away from core hospitals.

Winners and losers Winners in this space will include the diagnostics suppliers, hospital equipment manufacturers, next generation digital

enable staff to work remotely whilst retaining accountability. Again, we expect to see business processes redesigned and new software built to make the process of working remotely as seamless as possible.

More than ever, managers will also need to find ways to track productivity rather than pure time spent at work.

healthcare providers and health insurers.

The losers from this big push to improve the availability and remote deliverability of healthcare will likely include general practitioners and the taxpayers across the globe who will be expected to fund these developments.

Digital transformation Regular Confidant readers will know that this is a well-established long-term theme that we have been investing in for a number of years now. However, we believe that the coronavirus crisis will further accelerate progress towards solving two specific problems that have been thrown into sharp relief very recently – how to serve customers when they can’t be contacted directly in person and how to enable employees to work remotely as effectively and efficiently as they can, away from a centralised office or other workspace.

Despite the pervasiveness of technology, many businesses still rely on meeting other companies face-to-face. This stems partly from trust concerns (for example, a need to “look someone in the eye” before agreeing terms) and the need to complete complex supporting documentation. With most employees now being forced to work away from the office, businesses are scrambling to rewrite processes and adapt them to the use of apps, video conferencing and electronic contracting where deals need to be closed remotely. Indeed, such has been the impact of the virus that the days of travelling across the world to sign deals in person may be largely over, with the cost and environmental impact being further pre-existing catalysts for this change.

Similarly, the inability of many employees to go into their usual office during this crisis has focused management teams everywhere on how they can effectively

Winners and losers Here, we see the winners being the enterprise software providers, technology services businesses, cloud computing enablers and the telecom networks. The losers from this huge shift are likely to be office property owners, the travel industry, transportation networks and the casual dining sector.

Ecommerce Ecommerce is another theme that we have been following for some time and we still believe that it has significant growth potential. The ‘social distancing’ that has become part and parcel of the coronavirus crisis is forcing people to shop online, in many cases for the first time. Like never before, this change in behaviour is likely to cause people to question whether they really need to visit bricks and mortar retailers for many of their frequent purchases. As evidence of this sea change in behaviour, some online grocers reached full capacity weeks ago and stopped signing up new customers. Others, meanwhile, have rushed to add capacity and have created thousands of new jobs in the process. We believe this trend is no flash in the pan and will continue, coupled with an acceleration of the move away from people and merchants having to handle ‘dirty’ cash.

Winners and losers For our fifth and final batch of winners, we will be looking to the big ecommerce players, customer-facing software providers, electronic payment platforms, local logistic networks and food delivery firms. As for losers, the biggest ones are likely to be physical retailers and commercial property owners. ● Spring 2020 — 11

W E A LT H P L A N N I N G

Starting the saving journey Svenja Keller Head of Wealth Planning Svenja explains how her team helps younger generations to shape their life goals and design a financial strategy to achieve them.

What are the biggest financial challenges facing young adults?

Even after the current crisis has subsided, I empathise with the pressures on them, which are huge. First off, there is the immediate challenge of having to juggle multiple calls on their time and money.

These may include; finding and perhaps changing jobs, paying down student loans and other debt, saving for a house deposit and in many cases having children. At the same time, they need to think about the long-term future and their life after work as they are constantly reminded that there is going to be little help available from the State or the old-style (and often generous) defined benefit pension. Their challenge is balancing these immediate and future requirements.

Whilst information about all of this is available, there is often too much of it and some of it is conflicting. Multiple sources from different media channels about saving solutions, for example, make it very hard for anyone to know where to start and who to talk to when it comes to setting priorities and planning. Meanwhile, modern marketing solutions constantly tempt them into spending more – everything is just a click away and many people are easily seduced by a social-media induced fear of missing out (FOMO). As a result, years can whiz by before many young adults sit down properly and get themselves organised when it comes to their finances.

That’s a pity as these earlier years are some of the most important when it comes to harnessing the power of compounding to boost their long-term wealth.

12 — Spring 2020

When should someone start to plan?

The earlier, the better. Take basic budgeting – it’s a skill that we should ideally learn at school age, from the moment we start receiving pocket money.

The faster people work out how to set priorities and understand the trade-offs when it comes to spending, the more disciplined they will be. It is vital to grasp the importance of saving early – even small amounts put away when someone is young can mushroom into meaningful sums later at little cost in terms of lifestyle.

Unfortunately, it is all too easy to fixate on the here and now – meeting the next mortgage payment, school fees invoice or credit card bill. The result is too little attention being focused on how things will look 20, 30 or 40 years into the future. This “recency bias” leads many people to miss the opportunity to really give themselves an early financial leg-up for later life.

That matters because compounding is so powerful over long periods. One of my favourite examples is if a grandparent puts a single contribution into a pension for a newborn child, it will grow into a bigger sum than somebody will achieve by saving the same amount annually for ten years between the ages of 40 and 50. That just shows what getting started early can achieve. Yes, it’s less exciting to save than it

is to spend money but the benefits of being a little bit prudent as a young adult can be huge further on. I ask people to think about it as making a gift to their future selves, something they will look back on and be hugely grateful for one day.

What stops young people from saving more?

Part of the problem is the messaging around saving, which can be quite depressing. A lot of the marketing out there tries to scare people with facts about quite how much they will need to save to achieve anything, whether getting onto the property ladder or funding life after work. It can all seem a bit overwhelming, especially when people can get a quicker, albeit short-lived, buzz from spending money now.

What we try to do is convince our younger clients that even small saving steps can lead to bigger things as long as they start early and harness compounding over time to do some of the hard work for them. We also emphasise that our approach isn’t based on giving up the things that people love but just making sure they can see the value in balancing priorities and planning for the future.

PERSONAL VIEW

How should they go about it?

The approach featured in a lot of industry advertising is the idea that we can spend first and then find a way to save what is left over, whether that is a few pence or many pounds per month. However, the truth is that most people get through whatever is in their current accounts – the more they earn, the more they spend.

So, a better approach is to set a goal, then work out the amount needed to be saved to achieve it and then set that aside systematically in a separate account. In order to fund a monthly savings target, we start to look at ways people can adjust their spending. We can help by asking them to make a note of their “mandatory” outgoings, on things such as mortgages, utility bills and travel to work. That helps to identify how much is being spent on other, discretionary items (usually a lot more than people realise at first) before we agree on ways to reduce it. This process must be personalised – there is no point in me saying, “cut out that daily cappuccino” or “cancel that gym membership” to someone to whom either or both might be important. However, once life gets back to normal, going out for fewer expensive dinners every month or reducing the frequency with which expensive clothing is updated and replaced, might work instead. I don’t ask people to make unsustainable lifestyle changes but rather to find ways to resist the pull of instant gratification and focus on important longterm outcomes instead.

A key step in our process comes when people can visualise the potential benefit of saving on a cash flow model. These

can be very simple or more complex – the aim is to show how someone’s income and outgoings will evolve over time and the impact this will have on their overall asset position, net worth (taking account of debt) and ability to achieve their future goals. We can help them to model different “what if?” scenarios and see the impact of certain choices as well as where what I call “pinch points” will occur.

Once someone can see what they may be able to achieve with the money that they save and how this could enable them to live the life they want, I find that they become much more focused on both their current spending and savings goals.

Why can’t financial planning be done solely via an app?

Some people will always prefer to take a DIY approach and that’s fine. However, most of the off-the-shelf digital solutions focus on the basics of saving or investing, but not on planning solutions. In addition, most people I meet have no idea where to start, or which app to choose. They readily admit that they don’t really know which questions to ask, so they can hardly be expected to come up with the answers themselves. For example, if I ask someone, “what are your goals?” they will often stare at me blankly at first because they simply don’t know or have never really thought about it. Unless they can get to that first base, an app isn’t going to get them very far. It certainly won’t help them to understand what they really want from life and how to set up their finances accordingly.

W E A LT H P L A N N I N G

What are the common traps young people fall into?

The pressure to conform to expectations is widely underestimated. When I first ask people why they want to build a plan, they will often cite very stereotypical goals such as funding a first home and starting a family. This is all perfectly fine and sensible.

Yet, when we drill a bit deeper, some people will admit that they would secretly love to do other things too – perhaps more travel, or quitting a full-time job to start a business. What is stopping them is a fear that these are just unaffordable pipe dreams. My view is that nothing should be off the table when it comes to lifetime goals and it is my job to identify them and then help clients to build a plan.

Where our cash flow modelling suggests that someone can’t fund everything they want, we can help them to decide how to prioritise and compromise. The aim is always to find a solution that works for them. For example, some couples are very keen to send their children to private school. However, as I mentioned in the last issue of Confidant (“Weighing up private school fees”) this assumption is worth at least testing to make sure that prospective parents are putting themselves in what could be a tight financial straitjacket – for example, they may both have to work full time for many years – for the right reasons.

In that context, I always ask people to think independently about how they will finance their futures. Some young people rely too heavily on receiving inheritances or some other windfall. These may never happen, or not in the way or timescales they assume. Sure, if they are fortunate enough to inherit something later, we can work that into their model at the time, but I discourage those sorts of assumptions too early on.

Another big trap is an over-reliance on expensive debt. The banks have just started revealing the annual cost of an overdraft. When numbers like 40% start popping up, people should open their eyes to the dangers. It is all too easy to slip into borrowing to fund the gap between what someone earns and what they think they want. It’s a slippery slope, especially when the resulting debt is expensive. For example, if you take out a personal loan

Spring 2020 — 13

W E A LT H P L A N N I N G

at an APR of 18% and leave the capital and accrued interest unpaid for 4 years, you will owe roughly double the amount you borrowed.

A budgeting exercise can help to really focus people on what they are spending on credit and why. In my view, it is important that people live within their means and separate out mandatory versus discretionary expenditure.

It is also part of my role to be realistic in situations where someone a bit less experienced might not be. Take the move to self-employment, which is a dream for a lot of the younger people I meet. What they need to realise is that many people who work for themselves put in long and often unsociable hours. Weekend work and short holidays are the norm for many as they feel they can’t turn down work lest it should dry up. Some people also fail to realise that once they are their own boss, their families will have no automatic safety net to cover illness, injury or even death. Whilst no-one likes to dwell on such things, it is my job to make sure they have thought through the worst-case scenarios even if they choose to then ride their luck. These conversations are more important than ever right now.

That all said, whilst I often talk about budgeting and the dangers of living beyond our means, sometimes, I come across the opposite problem. Some people get so hooked up on saving for the future that they forget to live for today too. I have had clients that were so focused on saving money for a house and into their pension that they hardly had anything left to live on and that, in turn, created issues for their relationship. Finding the right balance is therefore essential.

Why should someone come to Killik & Co? Young adults face two main problems: They can fall into the “advice gap”, where the cost of advice is disproportionate to their wealth.

Or, they have access to advice but face too much choice and become confused by the different models available to them from the firms in this space. An independent financial adviser, for example, will deliver many specialisms through one person, a solution that can lead to a lack of in-depth knowledge. At Killik & Co, on the other hand, we can offer different specialists, depending on a client’s needs. A planner here can develop the bigger picture strategy and provide technical structuring advice, whilst an investment manager can offer knowledge and expertise when it comes to making money work hard. We also offer tax and trustee specialists to help with tax returns, wills, powers of attorney and trusts. That combination brings a wide level of expertise to the table, albeit that might mean that we need to spend a bit more time up front gathering all the relevant information and implementing the best possible plan for an individual, couple or family. The first meeting is always free and is mainly about information gathering. From there we can build an initial model which gets refined in subsequent meetings as we gather more detail and focus on priorities and the choices needed to achieve stated goals. For an illustration of the sort of cash flow modelling we can provide in relation to a property purchase, please see the case study that follows below.

Why worry? (fincap.org.uk)

Here are the key findings from a recent fincap survey of UK consumers.

21%

of UK adults rarely or never save.

47%

have not decided on their financial goals for the next five years.

51%

couldn’t last three months or more if they lost their main source of income.

61%

do not focus on the long-term.

63%

do not feel they are in control when it comes to money.

Killik Explains

To watch Tim’s educational videos on all aspects of saving, planning and investing, please go to killik.com/learn.

Whilst we can provide planning and investment management on a standalone basis, most of our clients prefer to engage us for both, usually because they like the convenience of having everything under one roof. ●

Case study The challenge

The solution

A husband and wife, aged 29 and 30, are both successful lawyers on track to achieving partnership. They earn £100,000 and £120,000 respectively and have accumulated £60,000 in savings. They rent a flat but would like to buy a property in five years’ time with a deposit of £200,000. They also want to stop work aged 60 and maintain an agreed level of spending in retirement.

Our first step was to put together an expenditure questionnaire which analysed their monthly spending line by line. This identified what they chose to term “mindless spending” of some £3,500 per month from a total joint net income of £11,000. They agreed that this could be saved, with an additional £2,400 still going into their pension.

14 — Spring 2019

The next step was to prepare a cash flow model which revealed that, subject to certain assumptions, a property purchase in five years’ time should be achievable without impinging on their ability to fund a comfortable retirement at 60.

PERSONAL VIEW

W E A LT H P L A N N I N G

Cash flow model example £12,000,000

£10,000,000

£8,000,000

£6,000,000

Stop fulltime work

£4,000,000

£2,000,000 Property purchase

Cash only (-2.0%)

All entered figures show the buying power of your savings in today’s money. The aim of this calculator is to give you an indication of how much you might need to contribute each month to reach your savings goals and takes account of any anticipated lump sum additions or withdrawals. The three calculations represent different Investment Approaches. Each Investment Approach represents a different level of risk that you would need to be willing and able to take. The calculator should not be regarded as personal advice. The actual returns (amounts) available will depend on factors including the growth your investments achieve, contributions

Low-case return (-1.5%)

Mid-case return (1.5%)

you make in future, charges and inflation. Charges on investments could be higher or lower than assumed in the calculation, which will affect the investment return.

Assumptions For the purpose of this illustration we have assumed: • Returns are based upon the FCA’s prescribed projections of 2%, 5% and 8%. These returns are adjusted for inflation (at 2.5%) and estimated fees (1.0% per annum) • Inflation estimated at 2.5%. This comes from the FCA’s Rates of return for FCA prescribed projections

95

90

85

80

75

70

65

60

55

50

45

40

35

29 30

£0 High-case return (4.5%)

• Growth rates are after estimated advice and investment management fees of 1.0% per annum.

(Any additional costs are not reflected in the calculation. If applicable, they would impact the overall return) • Taxes are not reflected in this calculation.

If applicable, they would impact the overall return •A sset allocation will vary based upon the investment approach • There is no charge for holding cash outside of your portfolio

The investment returns shown in this illustration are a guide, are not guaranteed and could be more or less than those shown. The forecast is not a reliable indicator of future performance. The value of investments can fall as well as rise, so you may get back less than you invest.

Spring 2020 — 15

CLIENT IN FOCUS

Finding your way around wine Queena Wong Founder of Curious Vines In difficult times, when many of us are drinking wine at home, Queena explains how she helps everyone from novice level upwards to increase their confidence when it comes to ordering.

She also offers some tips for anyone seeking a glass of something new over the summer.

Where did your enthusiasm for wine first spring from?

People sometimes expect me to reveal a “eureka moment” when I was converted by trying a particular bottle. However, in my case the turning point came when I met a wonderful sommelier at a restaurant many years ago. He pleasantly surprised me by taking the time to really listen and understand my preferences before making a recommendation based on them. I realised then how frustrated I had become, during a career in the City, at my own lack of knowledge and confidence after being regularly surrounded at events and dinners by people who seemed so assured about wine.

Soon afterwards I got in contact with a friend who was a wine merchant and started attending his tastings. Pretty quickly an initial curiosity on my part snowballed into a desire to learn as much as I could.

He was brilliant at breaking down the language barriers around wine and helping me to channel my natural enthusiasm by encouraging me to really understand what I like, what I don’t and why. I only realised years later that he was a Master Sommelier and one of only 230 in the world.

Fast forward and I am delighted to say that, through Curious Vines, I can now mentor and guide people who are in a similar position to my own back then and try to make wine less daunting. These days I am supported by royal warrant merchants such as Justerini & Brooks and Corney & Barrow. In normal circumstances, I also have the opportunity, through Venue Partners, to run events at locations such 16 — Spring 2020

local environment. My personal favourite outlet is the Theatre of Wine, near my home in Greenwich. I also love Connaught Wine Cellars in Mayfair, mainly for their huge range of French and Italian wines. Wherever someone lives or works, it won’t usually take long to find a good merchant nearby.

as 67 Pall Mall, Hedonism Wines and restaurants such as HIDE in Mayfair and Les 110 de Taillevent in Marylebone.

Why do some people find wine intimidating?

I think for the same reason people also find it so fascinating – its endless complexity. When they start out most people are daunted by the sheer number of producers, regions and grape types plus the fact that a producer can make several types of wine from a single grape variety.

It quickly becomes apparent that no matter who they are, the more they know the more they realise they don’t know.

So far, so scary you might think. However, one of my key messages to newcomers is that it isn’t our job as consumers to know everything. There are plenty of experts around already who know all of the minute details about wine and will always be years ahead of us. Rather, we should focus on getting to grips with our personal preferences and palate because those will naturally drive us towards certain regions, grapes and producers. These days there are many sources of information and help available to someone trying to master all the wine basics, for example; ●

●

Online searches – it takes just a couple of minutes to look up a bottle on Google. If someone wants to go a step further, they can try reading articles by respected critics on a site such as Decanter or use an app such as Wine Searcher for information about bottle prices.

Independent wine merchants – a good one will know lots about the wines on their shelves and will be happy to guide novices as well as more experienced consumers. Yes, most of us will probably pay a little more per bottle than we might at the supermarket, but I think this is a price worth paying for the opportunity to learn in a safe,

●

Sommeliers – the best ones are highly trained professionals who should wear their qualification badge with huge pride in my opinion. The new breed tend to be a lot less snobby and more approachable than was once the case and most love to share their passion and knowledge. I will always consult a sommelier on a special occasion and have often come away having tried something new and interesting.

How should a novice approach a new wine?

My advice is to engage as many of the five senses as possible. All too often people focus on just two – smell and taste. Since both are highly subjective, different people won’t necessarily respond to a wine in the same way. That’s because these senses are influenced heavily by our smell and taste memories, which are formed from birth and alter with age. For example, I had a lot of Chinese cuisine growing up, so my palate developed around the flavours my mother favoured using ingredients such as shiitake

mushrooms and soy sauce, both of which are umami influenced. My smell memory is therefore not going to be the same as someone else’s, which in turn will influence the smells and tastes we can recall most easily. Our palates develop on the back of familiarity and repetition, just as our bodies do when we regularly go to the gym.

I also urge people to slow down (no glugging!) and use their eyes. They should start by looking closely at colour and clarity, both of which can reveal plenty about a wine even before they take a sip.

Above all though, I try to get people to focus on texture and the feeling a wine gives them once it is in their mouth – in winespeak, “structure”. This is far less subjective than taste and smell and will usually fill a big part of any discussion between wine aficionados. The way I explain it is to ask people to liken it to a human skeleton – there are four key components, being a head, arms, legs and a spine. In just the same way, every dry wine has four key structures; alcohol, acid, tannin and body. Master these and much of the subjectivity disappears and novices therefore reduce their odds of being “wrong” and losing confidence.

Take alcohol content – we all know it is there, but we can feel and gauge it through a wine’s “warmth” (think of the way a tumbler of single malt whiskey makes your mouth feel). A wine where that warmth travels further down your throat will tend to be higher in alcohol. That naturally leads people to want to understand why one wine may have a higher alcohol content (calibrated as alcohol by volume, or ABV) than another. Confidant readers may already know that the answer is linked to the higher sugar levels in fruit grown in a warmer climate, which in turn means more alcohol is produced as it is vinified to remove that sugar. Once people start to understand this sort of thing, analysing a wine becomes a more logical, rather than a subjective, process which I find helps to build confidence. That is why I spend a lot of time on structure initially, rather than pure smell and taste as people might expect.

Do you have any rules for matching wine with food?

I have three basic ones – aim to match the two, contrast them or just drink what you like best. All are valid approaches.

Matching, for example, is all about

PERSONAL VIEW

picking, say, a strong red to accompany rich food. That’s what makes steak and Bordeaux a winner for many people.

Contrasting, on the other hand, would see someone pair the creaminess of certain cheeses with a champagne (which has natural acidity), whilst combining the saltiness of something like Stilton with a sweet wine. The third route is to drink what we enjoy – the “white wine with white food” rules of thumb have long gone.

Why did you start Curious Vines?

The inspiration came from two sources.

Firstly, many of my own middle-aged friends have partners who are wine lovers.

Yet far from bringing them together, wine was driving some of them apart.

This is particularly common where one partner has huge knowledge and confidence which can leave the other feeling intimidated and excluded around the dinner table or at an event. My belief is that everyone should be able to talk freely about something they love and often all that is required is some basic knowledge coupled with the opportunity to explore and discuss wine in an unintimidating environment – what I call social learning.

I have also become something of a magnet for a younger crowd who find that my consumer background makes me accessible and someone they can relate to as a source of guidance. I am good at simplifying wine for those just trying to find a way to approach it.

I set up Curious Vines with the intention of opening the wine world up to both groups and indeed anyone with a desire to expand their own knowledge and appreciation through a mixture of tutorials, tastings discussions and dinners.

Can you pick three of your favourite wines?

As we are approaching the summer months, I have chosen a couple of wines accordingly. My first is a slightly sweet

CLIENT IN FOCUS

German Riesling called Dr. Loosen Urziger Wurzgarten Riesling Spatlese Mosel.

I would urge people to forget any preconceptions they may have from when this type of wine had a poorer profile and give it a chance. This one is not too alcoholic, or too sweet and I like to drink it as an alternative to a traditional Pimm’s and Lemonade. Urziger Wurzgarten means spice garden and I love the hints of gentle spice that accompany its acidic zestiness (think lemons, limes and even a hint of tangerine), which keeps it crisp and fresh on a sunny day. It costs around £16 a bottle and at 7-8% ABV, it shouldn’t result in many sore heads.

Next up is a rosé. Whilst many people position pink wines as an aperitif, Chene Bleu Le Rosé has enough character to successfully accompany food too. The producer is a ground-breaking winery situated high up in a UNESCO biosphere within the Southern Rhone that refuses to play by the traditional French AOC rules.

The result is a trailblazer for the “Super Rhônes” that has won a flurry of awards and garnered much critical acclaim for brand ambassador Nicole Rolet. Their 2013 for example was the highest scoring rosé in an expert blind tasting that included competition from the likes of Ott, Tempier and Miraval. Expect to pay about £20 per bottle.

Now for my special occasion red wine – Tenuta Terre Nere Pre-phylloxera Etna Rosso from Sicily, which retails at around £85 from Hedonism. The grapes come from vines that are over 130 years old and which therefore survived the ravages of the phylloxera aphid that wiped out many European vines. As such production is limited and, sadly, in slow decline.

Anyone who can get hold of it will enjoy a wine of superb elegance – imagine floral tones, spice, depth and grip from a mixture of local varietals Nerello Cappuccio (2%) and the pinot noir-like Nerello Mascalese grape (98%).

If you could offer a novice one tip, what would it be?

Don’t be swayed by someone else’s recommendations unless you know that they enjoy the same style of wine as you.

Confidence around wine is all about owning your own opinion. ● Spring 2020 — 17

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

Weather-proofing portfolios Peter Bate Portfolio Manager Peter sums up his thoughts on four stocks that should be well-positioned to ride out volatile markets. Please note that these ideas are not covered

by Killik & Co Research.

One of the challenges facing larger companies has become apparent as the coronavirus has ripped through economies all over the world. In order to reach the size that they do, big firms need to win large positions in sizeable markets, or at the very least gear themselves up to do so in the future. Smaller companies, on the other hand, tend to focus on the more niche markets that tend not to bear the brunt of an overall fall in economic output to the same extent.

This is not to say, however, that smaller companies are therefore less risky by definition than their larger peers – as the ramifications of the COVID-19 outbreak have become clearer, small cap indices across Europe, the US and the UK have seen substantial drops. A key factor in this is a relative lack of liquidity – when prices are marked down indiscriminately, they can reach levels that prevent all but the most distressed sellers from trading.

Simultaneously, institutional investors hold back from buying as they anticipate redemption demands from their funds.

The good news is that this shouldn’t trouble investors who are able to avoid putting themselves into a position where they must dump stocks (“forced selling”).

Indeed, this sort of situation can often create opportunities. In this edition of Confidant, I want to outline some holdings with the sorts of business models and strong balance sheets that we feel should shield them from the trading losses being suffered by many other firms in this tough environment.

MJ Hudson – professional profits MJ Hudson is a provider of professional services to the alternative investments sector, and funds in particular. This part of the market has grown dramatically over 18 — Spring 2020

the last 15 years, as investors everywhere seek more routes into uncorrelated assets (especially in the wake of a period of heightened volatility) and fund managers continue to look for “sticky” assets, such as funds with long lives (here 7 years or more).

Professional services firms are generally not good at marketing themselves and so when we found one with a unique approach to acquiring clients, we knew it would be worth a further look. MJH’s proposition begins when funds are first established, a stage at which it can add value by offering them advice on how to structure themselves. Once a fund has been set up, it can then provide administration, regulatory and compliance services as well as in helping with marketing. The icing on the cake is the firm’s ability to also offer high-margin data and analytics products, built on data sources that may be difficult to replicate elsewhere. As a professional services firm, MJH should be able to easily cope with staff (and customers) adopting home working, whilst the coronavirus persists, albeit a prolonged lockdown could impact new business development.

The company raised funds as part of a listing on the Alternative Investment Market (AIM) in December 2019 with the intention of undertaking a “buy and build” strategy. As a result, it is very well capitalised (with net cash after earn out payments of around £15 million), which should give investors additional comfort.

Accrol – roll up We make no apology for mentioning this company in consecutive issues of Confidant.

It has one of the best management teams in the UK market, who have successfully implemented just about the most comprehensive restructuring plan we have seen at a listed company. The measures they have taken include reducing overall group headcount by more than 40% and bringing stock keeping units (SKUs) down by over 70%, with tissue types down by a similar percentage. Moreover, as a leading supplier of

own-label toilet roll to the large UK grocers, we suspect that the threat of bare shelves has rather shifted the balance of power between Accrol and its customers.

We further believe that market forecasts for both the current and next financial year are too prudent, especially given the significant demand the group will be facing as a result of coronavirus stockpiling (albeit there will be an element of pulling forward of demand as customers take a while to use up excess product).

Overall, having been under pressure for many years, we therefore now believe the company is on a strong growth tack. It may also offer an attractive platform for a much larger own-label hygiene business, given its strong entry points into the grocers and discounters, either as a target, or as an acquirer. The shares trade on 6.7 times April 2021 earnings with modest gearing (1 x EBITDA).

Boku – clicking along Boku is a provider of online payment processing and identity verification services.

The key asset of the group, built over more than a decade and backed by more than $100m of investment, is its base of direct connections into the billing systems of 190 (and growing) mobile network operators (MNO’s) around the world. Boku monetises these connections in three ways: Direct carrier billing (DCB) This is the process whereby a mobile user can buy online services (such as apps or films and increasingly media subscription services) by charging them to their phone bill rather than by entering credit card details. This improves conversion rates for anyone who wants the minimal hassle

or who doesn’t have a card to hand. It is also vital when selling to geographic areas where overall credit card penetration is low. As the firm’s core profit engine, DCB is a key component of our “sum of the parts” valuation given the group is the sole aggregator to Apple, Facebook, Netflix, Sony (PlayStation) and also supplies Spotify, Microsoft (Xbox) and Google Play (Android App store).

Identity solutions This business segment uses real-time data provided by the mobile network operators (such as phone location, number and SIM card status) to help mobile users to prove their identity. Customers include PayPal, Uber and Western Union. Whilst the bulk of current business is done in the US, the group is rapidly securing “supply” (i.e. consumer data access) arrangements with its mobile network operator (MNO) partners in Europe and Asia. By the third quarter of 2020 we expect to see supply arrangements in place covering the vast majority of Western Europe, India, China and Indonesia. e-Wallets Whilst in the US and UK, Visa and Mastercard are dominant, in many Asian and Latin American markets payment ecosystems feature a much larger number of e-wallet providers. The best known are Alipay and WeChat Pay, which combined have more than 1.5bn users.

Estimates suggest that more than 50% of all e-commerce in Asia is undertaken via e-wallet – Boku offers 10 e-wallets in 9 countries, giving it access to 1.4 billion users, compared to more like 1 billion users connected via DCB. The opportunity lies in the scope to link up the merchants it has as clients in Western markets (such as Apple, Netflix and Sony) to these wallets via the existing connections it has with them on the DCB side.

Overall, Boku is decently profitable and cash generative and has around $25 million of net cash on its balance sheet.

We believe the shares are undervalued based on its existing operations. Better

PERSONAL VIEW

still, that is before considering the optionality within the e-wallets division which could be serviced with the existing infrastructure and much of the existing merchant base. Recent commentary from the firm suggests that as people have been confined to home as a result of social distancing measures, they have seen a commensurate increase in activity levels across their various services.

Aquis – trading up Aquis is a pan-European equities trading exchange and a competitor, albeit a small one, to the likes of the London Stock Exchange, Chi-X or Turquoise. It also owns what was formerly known as NEX. The group was founded in 2012 by the former CEO of Chi-X, following its sale to BATS in late 2011.

It offers two key points of differentiation from its peers: Pricing Aquis offers a tiered structure whereby members pay a fixed monthly fee for as many trades as they want to do within set volume bands. Market makers, on the other hand, do not pay to trade. The rationale behind this subscription model is to encourage liquidity by effectively reducing the marginal cost of trading to zero.

Zero high-frequency trading (HFT) This exchange does not permit HFT strategies as it views them as inherently parasitic and a contributor to worse prices for real buyers and sellers. Removing the drag created by additional trading costs can only be a good thing for asset managers. This strategy has allowed the group to quietly build a market share of around five percent of the entire volume of continuous trading within the European markets in the second quarter of 2019. More interesting still is the fact that the group has a much higher proportion of liquidity “at best” (i.e. at the market’s best price at the time of the trade), estimated at around 20% and second only to Chi-X which had a peak share in the first half of 2019 of around 25%. This is the most compelling argument behind our belief that Aquis will grow market share, as it becomes increasingly difficult for brokers to argue that they are fulfilling their regulatory obligations around “best execution” of client orders without using them.

Aside from making money from exchange subscriptions (which generated £2.7m in the first half of 2019), the company also

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

monetises its technology by licencing its transaction matching technology to other exchanges (generating £744,000).

To avoid cannibalising its own revenue, the group focuses on selling to exchanges that trade assets other than equities, such as reinsurance instruments, infrastructure bonds and blockchain assets, and that operate in other geographies.

At present Aquis is close to breakeven, with a £550,000 loss expected for the 2019 financial year and EBITDA of £300,000 expected in 2020). By its nature, this business carries high levels of operational gearing, thanks to a high fixed cost base and a near zero marginal cost associated with incremental volume.

With this in mind, we see several potential revenue and profit drivers, which are likely to increase at a faster rate than current market expectations. These include the upselling of additional functionality to existing clients – for example, a low-cost auction product, which we believe has annual revenue potential of £6.5 million, yet appears to be absent in market forecasts. Another potential source of revenue is a “consolidated tape”.

This forces exchanges to pool their data with a central repository, which then repackages and sells it. Data suppliers (i.e. the exchanges) are paid a fee paid based on their market share. This system already exists in the US and we believe it is being considered by the European regulator with an annual revenue opportunity for Aquis (of essentially 100% margin revenue) of around 5 million euro.

As Aquis crosses into profitability and starts to position NEX as a genuine challenger to the AIM market, we could see both earnings upgrades and multiple expansion. If earnings progression takes longer, the company will be cushioned by around £10 million of net cash on its balance sheet. Meanwhile, trading volumes are likely to be elevated for some time, which will push clients up through the firm’s tiered pricing bands. Should today’s difficult trading backdrop persist, we would also expect to see fund managers migrating towards exchanges like this that offer the same functionality as their rivals but at a lower cost. ● Spring 2020 — 19

A DAY I N T H E L I F E

Talking technology Mark Furness CEO of essensys Mark explains how he turned a hastily scribbled idea into a software solutions empire.

How did you join your first technology business?

Throughout my school days, I was always a bit of a computer geek. Creative? Yes. Musical? Yes. But also quite nerdy when it came to the relatively primitive IT that was around then – these were the days when the Sinclair ZX 80 & 81, Spectrum and Commodore 64 were household names.

That said, on leaving school I temporarily set aside my true calling and joined a pop band sponsored somewhat prophetically,

by Commodore computers. We were called “Jazz Amiga”, after a popular computer of the same name. As a result, we were invited to play at the bigger Commodore conferences and corporate events. At one massive gig in Istanbul, we got to meet the global CEO, who turned out to be one of the coolest and nicest men I’d ever met. What also marked him out was his air of success.

The day after that event, I recall waiting to meet him for breakfast back at the hotel. He was delayed because he had been on the hotel phone to his girlfriend in Switzerland the night before, had fallen asleep and woken up that morning with the line still open. At reception, he was presented with a huge bill which he proceeded to laugh off, at least in front of us. There and then I thought, “wow – how wealthy are you?” and realised that my future didn’t lie in music but rather in computers and technology.

That led me into several roles with various firms, the most formative of which was when I was in my mid- to late-twenties .

It came about following a meeting with a businessman based in Monaco who specialised in buying and turning around troubled firms (a.k.a “distressed assets”). He owned one in Manchester that operated as a telecoms and IT reseller as well as being a maintenance company. It had struggled for years with a host of different people trying 20 — Spring 2020

to run it. I couldn’t understand why because to me, the business model seemed simple.

Whilst the firm was busy looking after really old phone systems and IT products and just about keeping them going, I felt they should have been approaching clients and saying “We can’t look after this kit anymore so would you like to upgrade to some new equipment instead?” It wasn’t rocket science. I pitched my plan to the owner in Monaco and returned to run the business in Manchester for the next two years. It was that full-on role that really acted as my business apprenticeship.

What went wrong?

I was a fast learner when it came to everything from strategy to day-to-day operational management. However, I’d come into the role aged 28 with no real leadership experience or anything on my CV that underpinned what I was doing. What I did have, however, was an instinct for business and a deeply ingrained appreciation of the importance of cash. I knew that as long as we had enough of it, we could get things done.

18 months after I started, the business was both cash positive and profitable.

I made mistakes along the way. An early one was convincing the business owners to get me a little sports car as an incentive to commute from Liverpool to Manchester. I then turned up at work in it on the day that I was due to deliver a load of redundancy notices – not my most empathetic move!

As it turned out, it would not prove to be my worst personal mistake – that would only become apparent later.

On joining the firm, I had done a handshake deal with the business owners for a 10% stake on the assumption that I would turn it around quickly. Fast forward those 18 months and we had grown to a successful 70-person strong firm. I remember a key meeting, when the main board all flew in from Monaco for a positive discussion about how well the firm was doing and our plans.

At the end of it, I seized the opportunity to ask about my promised stake. However, rather than confirming it there and then, as I was expecting, they offered me 2.5% tranches over the next four years instead.

Despite my protests, they were not prepared to budge. I said, “if that’s the case, then we can’t work together.” I left there and then, without anything to go to.

The next phase of my life was tough.

Feeling cheated, I hit a mental low. With only meagre savings to my name, which were exhausted pretty fast, I ended up in a mate’s spare room while I worked in a Thai takeaway in Earlsfield, south London.

How did essensys come about?

Although I had hit rock bottom, emotionally and financially, I always maintained a little notebook which I filled with ideas for the look, feel and culture of the business that I knew I would create one day. I had a light bulb moment one evening as I looked back ruefully on the business I had left in Manchester. I suddenly realised that their whole user journey had been a mess – even simple things, such as switching on a new phone or connecting to the internet, had been absurdly complicated and seemed to involve endless visits from engineers. It dawned on me that if I could automate all that mundane but vitally important stuff – by making it, in effect, self-service – I could transform the way IT was being delivered. In a nutshell, I wanted to replace the existing, widespread model of cumbersome internal IT, supported by expensive outsourcing, with software.

By taking out an army of network engineers

and system administrators I would make businesses more customer-oriented, improve their operationally efficient and save them money. At this stage my idea was just that – I knew that nothing I had seen on the market fitted my brief but my own knowledge of the technology required to build a solution was frustratingly limited.

To make ends meet, while my idea simmered, I took my brother’s advice and joined another technology firm in late 2005. There, I ran into the guys who would become my two co-founders at essensys, Bryn and Barry. Over dinner one night in Clapham I explained my idea and offered them 5% of my nascent business in return for £10,000 cash.

Somewhat to my surprise they agreed, and we started the business later that year. It would be another four years until we got our software solution delivered and installed at a client.

What was the secret to your subsequent success?

The key to it was hitting on the right market opportunity provided by the fast-growing co-working sector. Back then, the market for rented office space was dominated by hard-up businesses that couldn’t get conventional leases. However, I shared the co-working vision around a new breed of shared workspaces that could transform the way smaller businesses operated. I could see the challenges clearly too, including their need for the tools that would look after the IT requirements of anyone using these new shared office spaces. The result was a perfect fit between our vision as a firm and the requirements of an exciting, transformative industry. We never looked back once we turned on our first customer interface for office services firm Avanta. By subsequently going “all in” and embedding ourselves deep in the co-working industry, we got closer to its challenges, problems and pain points and turned ourselves into something of a “must-have”.

Another key part of our success has been the simple power of what I call “really giving a damn”. We have fostered a culture of constant innovation and improvement, always with the end customer in our sights.

Finally, it probably goes without saying that we have all worked like demons to get to where we are now.

A DAY I N T H E L I F E

What have been the biggest challenges?

Quite a few of them are personal. Although I have an amazing company full of talented people, getting to this point required all the self-sacrifice that you read about in business autobiographies. The hardest aspect of growing a business rapidly was the isolation and sense of loneliness. All I thought about for years was the health of the firm and the decisions I was taking. It can be hard to find a reliable mental and emotional sparring partner when you are in that position as you can’t trust many people to give you the right advice.

From a business point of view, our biggest challenge has also been one of our greatest strengths – we have always relied on our own cashflow to grow. We had little choice as the funding landscape for a firm operating in an unexciting part of the real estate industry when we started out, was barren. Senior bank debt was available, but it was predicated on us generating cash flow that we just didn’t have available. As a result, we were forced to grow the hard way by squeezing the most from everything – our people, premises, cash and above all our lines of code.

How hard was your subsequent expansion into the US? We’ve been very forensic about every business decision we’ve made. Like other firms, we had always looked at the US with a degree of nervousness, but we knew through thorough research and countless meetings that there was a market for what we were offering. However, by itself that is never enough – we also had to be iterative and incredibly agile to turn a UK business into a US success. We knew that our technology was far ahead of anything else on offer over there, but we also had to get it into the hands of customers and prove its worth. We achieved that, in no small part, by retaining our British identity rather than trying to Americanise the business.

As for what does keep me awake, it tends to be ideas. Once the day’s events have been processed and dealt with in my head towards the back end of the evening, I’d prefer to be able to settle down and get a good night’s sleep. However, that’s usually when an idea will pop into my head. And as soon as my brain picks one up, it runs with it, whether related to scenario planning, the markets, or something else entirely. The next day I’ll review the notes I made the night before and either dismiss my thoughts as the ramblings of a madman or take them to my business partners to get some independent feedback.

What would you say to the 18-year old you?

Firstly, stop being so hard on yourself.

Growing up, I was always my own worst critic and looking back I should have given myself more of a break by believing in who I was and what I could achieve. You’ve got to be yourself in life, yet I was very afraid to do that when I was younger and suffered for years from classic “imposter” syndrome – the fear of being found out as some kind of fraud. Another good piece of advice, which in fairness I heeded with essensys, would be to remember that talent without application gets you nowhere.

What keeps you awake at night now?

If you had the chance to join any band, which one would it be?

After 14 years in this business I can tell what doesn’t – things going wrong. As a CEO, you must be constantly ready to react when things change for the better or worse. I have learned to understand what I can control and the rest I accept that I must manage. Like me, my teams are drilled in thinking on their feet and for themselves. In the current climate that is proving essential.

I would love to sit on stage behind Stevie Wonder. The guy is outrageously talented and has worked incredibly hard to create what I consider to be the world’s greatest song collection. His current drummer is one of the most talented who has ever lived so I’d be happy enough just to be invited on stage to shake a tambourine behind him! ● Spring 2020 — 21

BOND RESEARCH

Grasping bond gyrations Mateusz Malek Head of Bond Research Mat explains what lies behind the recent dramatic moves in bond prices and why investors need to look beyond the headline numbers.

Abandoning tradition Bonds have typically performed well in times of market turmoil. As investor risk aversion mounts, they tend to seek the relative safety of less volatile fixed income securities. However, recent market events have challenged this wellestablished pattern. The unprecedented volatility that has been hitting global markets in recent months reveals that in times of tremendous stress, traditional relationships, across all asset classes including bonds, can become dislocated.

March madness This became very clear during March, when even the most stable and liquid of government bonds proved difficult to trade.

The sheer pace at which markets unravelled brought to the fore the importance of liquidity. With price swings at their most extreme, many corporate bonds became almost untradeable – market makers were not able to display prices in many securities, including some of the highest quality names. That left investors seeking to “buy on the dips” unable to do so thanks to the lack of inventory on offer, whilst any forced sellers struggled to find bids. Meanwhile, as many bond-based Exchange Traded Funds (ETFs) and closed-ended funds came under selling pressure the prices of those vehicles fell to create record discounts to their underlying net asset values (NAV).

Lifting the bonnet After years of very strong performance, such a sharp market sell-off acted as a reminder to investors that not all bonds are created equal. Whilst fixed income may be viewed by some as a unified asset class, the reality is that this broad term covers a whole range of securities from government issues, through to corporate and asset-backed. It is a market that encompasses different structures, seniority levels, credit quality, durations and liquidity. So, whilst the highest quality government bonds, which include UK Gilts 22 — Spring 2020

and US Treasuries, will usually perform well during periods of heightened risk aversion, the relationship tends to weaken further along the bond risk curve.

Spreading risk Unlike say gilts, corporate bonds provide investors with exposure not only to interest rates but also to the economic cycle. As such, they would typically see price falls when company fortunes deteriorate whether a function of profitability declines, increases in debt or declining interest cover (the ability to meet interest payments out of profits or cash flow). The higher the perceived risk associated with purchasing a given corporate bond, the wider the yield differential will therefore be between that bond and a government bond with a similar maturity. This gap is often referred to as a ‘spread’.

When markets sell off, particularly during periods of economic weakness, that spread differential widens, as investors demand a higher yield in return for accepting increased investment risk. A spread will widen more on bonds that are issued by companies with a lower credit standing, as they are more likely to struggle in a more adverse economic environment. Bearing in mind that bond prices move in the opposite direction to bond yields, a larger move in a spread (and therefore yield) will lead to a larger price readjustment. Sure enough, during the four weeks between the 21st February and the 20th March the average spread on a “BBB”-rated (the lowest in the “investment grade” category) sterling corporate bond increased from 150 basis points (bps) to 323bps, whilst an average “BB”-rated bond’s spread (the highest level of sub-investment grade) spiked from 276bps to 641bps. For similar duration bonds, therefore, the price fall in a “BB”-rated bond was more than twice of that of the average “BBB” bond. However, the picture changes for bonds with different durations.

Duration pain To be able to calculate the full impact of a spread change on the price of a bond, we also therefore need to know a bond’s duration.

Bond maths dictates that those with longer

GBP IG Index Total Return 150 140

GBP HY Index Total Return GBP IG Index Total Return

130 120 110 100 90 03/15

03/16

03/17

03/18

03/19

03/20

Source: Bloomberg

durations will see a greater cash price move for a given change in their spread. This matters in the context of the March sell-off (see chart), when the Bloomberg Barclays Sterling Investment Grade (IG) Index fared only slightly better than its lower quality High Yield (HY) equivalent (the peak to trough declines were 13.3% and 16.2% respectively). This was despite the much higher quality of the underlying IG bonds, which had an average spread that was one third that of their lower quality, high yield equivalents, (119bps vs 382bps). This reinforces the point that it was the duration factor that played the bigger role in the IG bond price deterioration – indeed, duration on the IG index, at 8.5, was nearly three times larger than on the HY Index, at 3.8.

Drilling down So far, the sell-off has been driven by expectations of a sharp economic contraction across the entire economy, rather than by concerns about the more highly indebted companies. However, if the current downturn lasts longer than is currently expected, we expect to see further credit differentiation. Declining profitability and credit ratings downgrades will likely lead to underperformance from lower quality issuers going forward.

In this tougher environment, bond investors should therefore look beyond the yields on offer and focus their attention on the quality of an underlying portfolio. I would argue that understanding the constituents and their specific characteristics has become more important than ever. ●

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

Making sense of market mayhem Rachel Winter Senior Investment Manager Our weekly Market Update presenter Rachel looks back at the tumultuous events of the last quarter and sums up some of the implications for investors.

Sickening stock markets Our headlines over the past few weeks have been dominated by the emergence and subsequent rapid spread of the coronavirus (COVID-19). Concerns became mainstream in early January when travel bans were imposed around the Chinese lunar new year to prevent its spread. The severity of the situation subsequently became apparent when China extended its usual stock market closure for an additional two days. The virus has since become a global pandemic with most major economies enforcing self-isolation.

The short-term impact on the global economy is likely to be severe – national debt will rise considerably given the extensive support measures that governments are putting in place for individuals and businesses. Central banks, meanwhile, have slashed interest rates to new record lows to help support markets and the economy (see also pages 6 and 7). Despite these measures, global stock markets have fallen heavily due to the inherent uncertainty around this virus outbreak. However long it lasts, we believe that the pandemic being witnessed globally is likely to have a lasting impact on how we live our lives.

Although some companies will be rendered extinct as a result, many others will seize the new opportunities that are emerging. For example, the businesses offering the kinds of software and services that are needed for working from home have experienced a huge surge in demand (see also pages 10 and 11). Microsoft, for example, has reported an increase in users of its Teams platform from 20m to 44m in just four months. Naturally, we will be monitoring developments very closely over the coming months.

Sliding oil prices Although the price of Brent Crude touched $70 in January, it tumbled to below $25 in March thanks to a steep reduction in — Winter 2019 23

demand. A number of Chinese factories were closed in January, to help prevent the spread of the coronavirus, and this had a notable impact on the overall demand for oil. Subsequently, in early March, Russia put further pressure on oil prices by pulling out of an output-restriction agreement with OPEC (Oil and Petroleum Exporting Countries) and announcing it would be raising its own supply. Saudi Arabia responded too with its own supply increases which have driven the price down further.

Investors pondering the ramifications of all this, along with any deal that is reached, may note that whilst the oil majors, such as BP and Royal Dutch Shell, should be able to survive a low price for a reasonable period of time (albeit with much-reduced profitability) smaller producers with high cost bases are likely to struggle.

Talking to China After weeks of debate, Boris Johnson announced that the UK will go against the advice of the US and allow the use of Chinese telecoms giant Huawei’s equipment for UK networks. The US has strongly advised its allies to avoid the firm over concerns that the Chinese government could use its equipment for espionage. The UK’s decision angered the US and has arguably damaged the relationship between Johnson and Trump. That said, Britain has set some rules around the deployment of Huawei equipment by, for example, forbidding its use close to sensitive locations such as military bases. Investors should be aware that amending their networks to fit with these new restrictions will be expensive for UK telecoms firms BT and Vodafone, who have said the decision will cost them £500m and £200m respectively.

Flying low Financial difficulties for domestic airline Flybe became apparent in February, and for a time there was talk of some government assistance to support the airline. However, the backlash against this move was huge, with leaders of other airlines lambasting the government over this potentially unfair support of what they viewed as a poorly managed business.

Flybe has since fallen into administration.

The airlines sector in general has now been heavily impacted by coronavirus with other carriers likely to run into rapid difficulties along with the sectors that are heavily geared to them, such as leisure.

Reframing global growth The World Economic Forum in Davos positioned climate change as its central theme. Whilst the impact of the coronavirus on the timing and extent of bigger projects in this space is yet to become clear, this is not a theme that is about to dissipate overnight. Key discussions took place with the big auditors around possible frameworks for measuring sustainability given the increasing need for standardised criteria. The minds of the great and good were further focused on climate change later in the quarter by a public letter written by Larry Fink, the CEO of the world’s largest asset manager, BlackRock. He highlighted the risks and opportunities that climate change could bring to financial markets: “…because capital markets pull future risk forward, we will see changes in capital allocation more quickly than we see changes to the climate itself. In the near future – and sooner than most anticipate – there will be a significant reallocation of capital.” Supporting his view, the UK government later announced that it would bring forward its ban on new petrol and diesel cars to 2035 although it’s yet to be seen whether this target gets revised in the light of recent events.

If you would like to watch my weekly video roundup of key market news and events, please keep an eye out for our weekly newsletter or ask your Adviser for the link. ● Spring 2020 — 23

The impact of Covid-19 on the UK has caused an unpredictable and turbulent time for all of our clients and their families.

I wanted to take this opportunity to personally reassure you that while life as we know it may currently be very different, Killik & Co is still operating business as usual.

We have always endeavoured to put out clients at the heart of everything that we do, and I can assure you this has not and will not change. While our locations remain closed, our business is very much open, as the firm as a whole now works remotely.

When it is safe to do so, and under further advice from the UK Government, we will once again open our doors. Until then, your Adviser is just a click or a call away.

I also wanted to thank you personally for your loyalty and strongly believe we can pull through these uncertain times together.

My very best wishes,

Paul Killik