It has been an unforgiving decade for value managers and the UK has been a particularly unforgiving market. UK-focused value managers have therefore had the toughest possible hand. However, James Lowen and Clive Beagles, managers of the JOHCM UK Equity Income Fund, have played their cards better than most, making them one of the most reliable long-term performers in the UK equity income sector.
Theirs is a process honed over 25 years of partnership. The pair first worked together at Newton and have been at JOHCM for 18 years. It is a collaborative process, rather than each taking responsibility for specific sectors or companies.
Lowen says: “We both do everything. Recently, we have had meetings with Currys, Galliford Try and Kier, and we alternate who leads it. Equally, we alternate our engagement with companies – trips to production plants, for example. It means there’s a lot of debate between us about every stock. As such, the hurdle to stay in the fund is very high.”
That said, each brings different skills to decision-making. Beagles is more ‘top down’, building views on the broader economic environment, while Lowen, having trained as an accountant, brings more of the forensic, bottom-up analytical skillset.
More recently, this has seen him looking in depth at Currys’ pension fund deficit and how changing bond yields might affect it. This ability to get under the skin of companies has proved invaluable in a tough climate.
There are checks and balances built into the process that save them from any of the deep value traps that have unseated other value managers. They look at normalised earnings, for example, modelling forward two to three years, rather than basing their valuation on the level of earnings today. They are also minutely focused on balance sheet strength. This has become an increasingly important metric for them over time and distinguishes them from some of their peers.
“We have lots of stocks with no debt at all and only 8% of the fund has a net debt to ebitda of more than 2x. This meant we only had one stock blow up in Covid-19. During extreme market events, leverage is the greatest risk,” says Lowen.
Focus on price
Lowen remains true to the value mantra that price is crucial. “If someone sat with me and Clive for a day, they’d be astonished how much we talk about valuation,” he says. “Where we make money is the price we buy at. Investors can buy good assets, but if they overpay, they’re not going to make any money.”
He believes people pay too high a price for ‘comfort’. At the moment, for example, it’s comfortable to own dollar earners. They aren’t impacted by the Bank of England’s actions or the dramas of UK politics.
However, with the dollar at all-time highs and sterling significantly undervalued on most measures, it isn’t an ideal time to buy them. Also, many dollar earners have been bid higher, because everyone wants them.
Lowen adds: “Investors are paying a higher multiple and their earnings are based on a high exchange rate. Where dollar earners are cheap, then we’ll look at it. And there’s a number of them that fit in that category – WPP, DS Smith. But for a large number, the currency is fully factored in.”
He says it is a similar picture with defensive stocks. As the economic environment has worsened, investors have rushed to the safety of defensive areas such as tobacco or healthcare, but this has left some of these stocks on high valuations.
Lowen singles out AstraZeneca, GlaxoSmithKline, Diageo, Unilever, Reckitts, British American Tobacco and Imperial Brands as particularly expensive. None are currently in the portfolio. He adds: “People overpay for comfort. We do the opposite.”
The fund currently has a yield of 3.82%. The pair is focused on dividend growth, and has created their own tracking system giving them an exact picture of their dividend position at all times. Lowen says: “We are notably better than our competitors on dividend growth. This is achieved by a relentless focus.”
He adds that every stock in the portfolio has to yield more than the market: “It’s easy for me to tell you why I like a specific company, but the hardest thing for any fund manager is to sell a stock they like. By ensuring that all the stocks we buy yield more than the market, we have a natural sell discipline. It forces valuation risk off the fund.”
An allocation to small- and mid-cap holdings has also been an outsized contributor to the fund’s overall return over time. The current 40-45% allocation is higher than average, with Lowen seeing plenty of opportunity. Sentiment towards domestically-focused companies has been negative, leaving plenty of good businesses at cheap valuations.
For this reason, the pair has been careful to restrict the size of the fund. Part of the appeal of joining JO Hambro was that then-chief executive Nichola Pease allowed them to set clear size limits for the fund and cap inflows periodically. The fund has been capped six times since launch. It is uncapped at the moment because there have been outflows – a reflection of the general unpopularity of the UK market.
The fund is not small, at £1.8bn, but this flexibility allows them free rein to search at the smaller end of the market.
The way the fund has been structured has been important to performance over time. However, the real secret sauce is the stockpicking. Lowen says the fund has outperformed in nine out of 11 sectors, with only real estate and technology marginally lower. Neither are significant weightings.
Lowen is surprisingly upbeat given the general gloom surrounding the UK. His enthusiasm comes from relative valuations. He says the value versus growth differential still has to normalise after more than a decade of strong performance from growth. The absolute price-to-book value of the fund is very low relative to history and news flow for companies within the portfolio continues to be strong.
“We see many of our holdings as a coiled spring at the moment. Valuations are at lows only seen at some of the crisis points in history – the global financial crisis, 1970s oil crisis, the TMT bubble bursting, Covid-19, Black Wednesday. At these moments, markets have troughed at about the same level. When everyone is panicking, it is time to be more constructive. That’s what we see today.”
However, he warns investors need to be careful where they are looking. Passive funds, he points out, will have around 25% in the “ludicrously expensive” defensives. He is finding opportunities among the more cyclical and domestically-focused names. “The UK is very much two markets. There’s an expensive bit – and we’re looking among the rest.”
He believes those expensive stocks look vulnerable to any shift in market sentiment. “Interest rates are going up. In the rest of the world, growth stocks are deflating because they relied on a low cost of capital. In this environment, UK investors might have expected these expensive ‘bond proxies’ to come off. They haven’t because of risk aversion.”
However, if risk appetite normalises, this would be a significant risk.
A key area for the fund is “growth in a value jacket”. He says: “Covid-19 and other events have shifted growth to our part of the market.” Lowen points to areas such as infrastructure. Companies within the portfolio include Costain and Galliford Try. They already have strong order books, but the government is prioritising further infrastructure spending, which should give them an extra boost.
Insurance is another important area for the fund. It is benefiting from higher interest rates but may also gain a Brexit dividend as regulation is reshaped for greater flexibility. The fund also has a significant weighting in mining and oil. Mining is a key beneficiary of the clean energy transition, while oil has been affected by the Ukraine/Russia crisis.
“Even if the war were to end tomorrow, these shifts will continue. Everyone is trying to move away from Russia to ensure we’re not in the same position again.” While these are ‘value’ sectors, they are backed by some powerful, structural growth. “We can have our cake and eat it,” says Lowen.
The higher weighting in small- and mid-caps is a reflection of the weakness of all stocks with any exposure to the domestic UK economy. Lowen sees significant upside for some of these stocks and believes the UK economy may not be as bad as the current expectations suggest: gas prices are dropping, wages are seeing moderate increases and the reversal of the national insurance hike will put money back in people’s pockets.
Lowen and Beagles remain among the most successful pairings in UK fund management. History suggests that if they see the market as a ‘coiled spring’, it may be worth paying attention.
James Lowen joined Newton Investment Management in 1998 as a member of their research department and moved to JOHCM in 2004 alongside Beagles.
Clive Beagles co-manages the JOHCM UK Equity Income Fund, alongside James Lowen. Prior to JOHCM, he worked at Newton Investment Management and managed the Newton Higher Income Fund.
This article first appeared in the December edition of Portfolio Adviser Magazine