UK equites; not as in favour as they were

At the end of September we made a significant change in asset allocation within the equity portfolio of the Diversified growth funds, where allocations are made to a UK portfolio and a global ex-UK portfolio reducing the UK weighting. We have been positive on the UK for some time and had very significant exposure; the reasons for the change of view are outlined below. The overall equity exposure remains unchanged.

Firstly, to give some context to the scale of the move, across the four growth funds, within the overall equity portfolio the target weights were split approximately 55% global ex-UK, 45% UK. This did vary a little fund by fund. Historically, we have considered target weights nearer 67% global ex-UK, 33% UK to be more normal, until we started favouring the UK more as it looked cheap by international and historic comparison and prospects improved. The target weights have now been changed to 70% global ex-UK, 30% UK. Whilst this move is significant, we are not far away from previous levels. Furthermore, with the UK only 3.28% of the FTSE All-World Index, we still have a sizable overweight position in all the funds.

Part of the reason we have had a bias to the UK is the expertise we have. UK equity fund managers, Jon Hudson and Benji Dawes, have produced excellent returns for the Diversified fund range over time, through adopting a multi-cap approach and finding great investments lower down the market cap scale. We still believe that there are great opportunities.

So why did we back the UK more of late? It’s something I have written on extensively over the last year or so, particularly the last few months. It was driven by a number of factors, including; valuation looked attractive by historic and international comparison, inflation had fallen sharply back towards Bank of England target levels, the economy had been stronger than anticipated, interest rates started falling, the consumer sector remained robust, corporate activity was taking place and following the general election, there was greater political stability.

However, more recently, a number of those positive factors have weakened and with the new government’s budget announcement at the end of October likely to herald revenue generating measures, we are concerned that those positives could further reverse, and economic growth could suffer. In other words, raising taxes does not lead to growth, certainly in the short to medium term. The burden is likely to be carried by the section of the population that is more entrepreneurial and generates growth, this could result in them being less incentivised or departing to other countries.

This has, as you would expect, impacted consumers’ confidence. The British Retail Consortium announced that their recent poll on consumers expectations for their personal finances over the next three months has dropped to a negative score of 6 from a positive one just a month ago. Also confidence in the state of the economy collapsed to minus 21, from minus 8 in August. I don’t think we can talk ourselves into recession, but there are real world ramifications of rhetoric and actions. It’s a similar picture being painted by businesses, where confidence has slumped, the Institute of Directors Economic Confidence Index reflects a similar outlook. Unsurprisingly, the UK stock market lagged most others in September.

Similarly, the Bank of England’s reticence to cut interest rates further could stall the economy.

I also fear that investment in the UK from international, corporate and private equity investors could suffer, the splurge of M&A activity has died down. It has also been reported that the largest sovereign wealth funds are no longer willing to look at UK utilities as an investment.

Reading that back, it does tell a rather bleak story. However, another key message is that we have retained a meaningful exposure to the UK, valuation still looks attractive and we can find many good companies that we want to invest in, we see this move as a risk management decision; if the UK continues to do well the funds will still benefit. Perhaps more importantly. Jon and Benji remain convinced of the good prospects of their holdings and took the opportunity of this switch to rebalance towards their current most favoured ones.

I really want to reiterate that we like the UK equity market, but not as much as we did.

Global equites; ripe with opportunity, but you need to look in the right place

Just as importantly, when we make asset allocation decisions like this, when reducing a weighting to an asset class, which is unusual on this scale, we need to find something to do with the proceeds. In this case, that was easy.

The money raised was switched into global ex-UK equities where we can also find a large number of exciting opportunities across different sectors, including timber products, pharmaceuticals and financials in regions as far apart as the US, Hong Kong and Japan. Let me provide some more detail on that. Again, as I have been writing about recently, we have been reducing the exposure to the technology sector in the equity portfolio, including selling out of NVIDIA, as those holdings, in our view, were, at the time, discounting unachievable growth rates. Furthermore, there were more opportunities elsewhere; some share prices were being left behind as investors chased the big tech companies.

We have been finding opportunities in long term growth companies at interesting valuations that resulted from share price weakness. Weyerhaeuser is a North American timber and wood products company that has suffered as many REITs have, from higher interest rates and associated higher yields available in bonds. In addition, higher rates have depressed the US housing market to levels that we see as being unsustainably low. With the rate cycle stabilising and with the first cut in US rates, we would expect to see an improving outlook for US housing which in turn should drive better earnings for Weyerhaeuser.

Japan has been appearing on the radar more this year. Daiichi Sankyo, a pharmaceuticals company, has seen more recent share price weakness following worse than expected clinical trial data for two of its cancer drugs. With a potentially strong pipeline of trial results to come and joint ventures with peers such as AstraZeneca dividing trial risk, recent share price weakness provided an opportunity to build a position.

Similarly, we took a position in the company running the Hong Kong Stock Exchange as a fall in share price saw the dividend yield move to an attractive level, driven by the sell-off in Chinese equities. The recent stimulus package announced by the Chinese authorities provides more evidence for the investment case.

Finally, we added a new position in Service Corporation, the US provider of funeral services. Although the share price had not been particularly weak, we still felt it was an opportune time to establish a position in a company that is the market leader, with a consistent track record of returning capital to shareholders.

These are all very different businesses in different regions, all with interesting prospects and diversify risk and the potential for return.

As we did with the UK portfolio, we will take the opportunity of this asset allocation change to rebalance the portfolio towards holdings that are currently more favoured, such as those above.

Finally

As ever, we will monitor the situation and adjust allocations as events and expectations unfold. These are actively manged funds in which we seek to adjust the risk / return profile for different economic and market conditions and outlooks.

We see an opportunity to adjust the weightings of the equity portfolio towards more favoured regions and companies at present and have made that change, that’s the job of an active fund manager.

We have not made a similar switch yet for the Premier Miton Diversified Income Fund, we need to consider the generation of the income paid by the fund before doing so. This fund typically has more in UK equities given the income they offer.

For the Premier Miton Diversified Sustainable Growth Fund, given the structure of this fund, where there is one equity portfolio covering global including UK equities, and the ESG and sustainability criteria applied to the fund and its investments, we do not specifically allocate to the UK, therefore no similar switch will be made.