Josh Herson, fund manager on the JO Hambro UK Equity Income strategy, discusses finding value where others are looking away, from housing-linked stocks to underappreciated UK smaller companies.
The Monday Manager series covers fund managers that have worked on their fund for over three years, and where fund assets are over £100m.
Can you explain the portfolio’s approach to investment and what it is trying to achieve for investors? How do you define “contrarian”?
Ultimately, we are trying to deliver a combination of long-term capital and income growth by investing in undervalued companies. We achieve this through our unwavering focus on valuation, our normalised earnings framework and our rigorous cashflow/dividend modelling which we undertake on a stock-by-stock basis.
While we are an income fund, we are not a coupon-clipping income fund. We want to own companies that have a superior dividend yield but also have very substantial capital upside because they are currently out of favour.
We also invest across the whole of the market-cap spectrum and this is a key differentiator. Currently, almost 50% of the fund is in mid- and small-cap stocks where we believe the valuation opportunity is particularly compelling.
To me, being contrarian is about having the courage and conviction to look in parts of the market others can’t or won’t. It’s not about being contrarian for contrarians sake. It’s about exploiting temporary mis-pricings, which are often driven by behavioural factors and sentiment, rather than fundamentals. This is what ultimately underpins our conviction in value investing.
Which areas of the UK market are you most excited about and which areas are you avoiding?
Although we are bottom-up investors, some of the most pronounced inefficiencies and opportunities can be found in the small and mid-cap segments of the market. Here many domestically orientated businesses are trading at significant discounts to intrinsic value.
Two areas we would highlight would be construction, including the broader housing complex, and companies exposed to the consumer. Although these businesses remain deeply out of favour with investors, the companies themselves are operating well.
The businesses we own are either market leaders or growing faster than the market, they have strong balance sheets and they are generating robust cashflows. We believe there is a big gap between perception and reality.
This is where we apply our normalised earnings framework and focus on a company’s durable, medium to long-term earnings power rather than short-term sentiment. We would note that savings in the UK are extremely elevated and consumer balance sheets are as strong as they have ever been.
The firepower is there, the missing ingredient is confidence. It is worth remembering that two thirds of UK GDP is derived from consumer spending. We would also note housing is evidently central to the government’s agenda.
We don’t actively avoid any areas outright but there are pockets of the market that just don’t meet our valuation and yield requirements. Currently that would include the defence sector and many popular ‘quality growth’ stocks where we believe there are structural question marks around particular franchises that are not yet adequately reflected in valuation. Having a margin of safety is a key part of our philosophy.
Could you talk through a couple of examples of high-conviction stocks in your portfolio?
A business that spans both the consumer and housing sectors is Wickes. Despite the overall weakness of the repair, maintenance and improvement (RMI) market in recent years, Wickes has continued to take market share and is well positioned to benefit from any normalisation as housing activity recovers.
Management, who we rate highly, have outlined an ambitious growth plan and have plenty of white space to grow into. Based on our normalised earnings framework, which is built upon highly prudent assumptions, we believe the shares can double.
Another business we would highlight is contractor Kier. This is a business poised to benefit from the vast infrastructure spend that is being deployed across a number of sub-sectors from highways to water to energy. This spend is reflected in Kier’s c£150bn of framework positions and record order book. The balance sheet is transformed and is now net cash. We therefore see a powerful combination of a multi-year structural tailwind, strong operational performance and an attractive starting valuation.
How positive are you in terms of finding new positions for the portfolio, compared to previous years?
Despite the strong performance of the UK market in recent years, and the headline index once again nearing all-time highs, the opportunity set remains broad and competition for capital within the fund remains high.
When market conditions are euphoric it is important to reinforce valuation discipline and ensure that the fundamental and value ‘hurdles’ on new investment ideas remain high. We have continued to do both and have been more active than usual in recent months.
The aggregate effect of this is that the valuation upside that resides in the fund remains material. This is evident both on a stock-by-stock basis, where our target prices imply an aggregate upside of more than 50% on average, and at the fund level through measures such as price-to-book multiples.
On the latter metric, the fund has only been cheaper relative to the market for around one year during the more than 21 years we have managed it.
What are some of the key themes affecting UK equity income managers over the long term, and how are you positioned for these?
A key theme/issue we are currently facing, and that will have long term implications, is that the UK market is under M&A attack. We have highlighted the stark valuation opportunity that exists across the market and currently overseas corporates and US private equity are taking advantage whilst the domestic capital base remains net sellers.
Quite simply, at the current rate of activity, we won’t have a meaningful stockmarket left in 10 years’ time. There have been six FTSE 100 bids alone this year and that rises to seven if include easyJet which had just dropped into the FTSE 250 prior to the bid situation.
Given the valuation architecture we anticipate this level of activity continuing. This will have wide ranging implications not just for those directly exposed to capital markets (investment professionals, lawyers, accounts etc) but for the broader economy.
It is vital to have a vibrant and healthy domestic capital market for the economy to prosper. M&A will be a big source of alpha, and we will likely capture our fair share, but it also reinforces a longer-term cycle of decline. That is why we would be in favour of a form of mandation, particularly around pension tax relief. In our view, if you receive tax relief, you should be prepared to have a minimum allocation to the UK market.
What is the best piece of investment advice you have been given?
For me, it’s probably that the best investment decisions are often very uncomfortable at the time. It’s really important to be disciplined, to stay true to process but then have the courage of your convictions.
I also think you have to be honest and brave enough to accept when you make a mistake. I also believe being humble and having a sense of humour is vital!
What make this job so interesting, and a genuine privilege to do, is that you learn something new every day and you just try to continuously improve.
