In the period leading up to the financial crisis, the BNY Mellon Global Income Fund outperformed rising markets. It was overweight Asia and emerging markets, financials and mining, cyclical and pro-growth stocks. In the period between launch in November 2005 and the collapse of Lehman Brothers in September 2007, the fund returned investors 29.1% compared with 16.1% in the FTSE World, according to FE Fundinfo.
“Then as we got into 2007, we saw the writing on the wall about the financial crisis. We changed the portfolio quite dramatically, from overweight to underweight financials,” manager Nick Clay (pictured) says. “We started to dial down the cyclicality and pulled out of the emerging areas, to the point where we had a portfolio that did the opposite.”
That defensive positioning, which was fully implemented by the end of 2009, has remained in place since the crisis, meaning the portfolio tends to underperform rising markets and protects on the downside, depending on the nature of the market rally. In the 14 years since launch it has returned 308.9%, compared with 253.4% in the benchmark.
Quantitative easing throws around fund beta
Quality at a reasonable yield is how a recent presentation slide describes the £5.7bn UK-domiciled fund, which dropped the Newton brand in September as part of BNY Mellon Investment Management’s rebrand of £27bn worth of funds.
Before 2007, the fund had a beta greater than one, which remained fairly constant, but Clay says that figure is now whipped all over the place, depending on what’s driving markets. The beta was 0.85 in the September factsheet.
“I don’t tend to look at the beta of the fund as it doesn’t tell you anything constructive in this environment, because the market has been manipulated by QE for so long,” he says.
If it’s an exuberant, risk-on market, the fund underperforms; but it will outperform when bad news gets the market excited about central bank stimulus, he says. “When yields are collapsing to zero in the bond market, we will outperform even though the market is going up.”
Nick Clay’s sell discipline
Although the fund dynamics have changed since launch, a strict buy-and-sell discipline remains, although the thresholds have shifted.
Since 2009, the investible universe covers stocks yielding at least 125% of the market. These are sold when the yield matches the market. The current yield on FTSE World is 2.6%, meaning anything in the portfolio must yield 3.25% or above. This results in a choice of approximately 750 stocks, a figure that has remained relatively constant.
Before 2009, the fund targeted stocks yielding 150% of the market and sold them when they hit 125%. Those parameters were initially put in place because it resulted in a fund yield of approximately 4%, which Clay deemed sustainable.
However, double-digit market falls during the financial crisis meant the universe ended up with higher-yielding and therefore riskier stocks.
The team analyses cashflow as a means of assessing dividend sustainability, using a 6% real discount rate regardless of sector “because that is the long-term return on equity markets”. The team, which includes fellow portfolio manager Andrew MacKirdy, who joined from Polar Capital in 2018, examines the likely outcomes for cashflows in various scenarios via fan charts.
Brexit problematic for valuation of UK domestics
This is one reason the fund is underweight domestic UK. It still has a decent allocation to overseas earners, however, with the UK representing 13.3% of the fund, after North America (45.5%) and Europe ex UK (30.5%), according to the September factsheet.
“Until we get clarity on Brexit I don’t think it’s possible to properly calibrate our fan of potential outcomes to make domestic UK stand up as genuinely cheap.” British American Tobacco, Informa and Unilever are the UK-listed stocks in the top 10.
In contrast, the team added to Bayer towards the end of Q1 2019 as the fan of probabilities suggested the risk/return asymmetry of the special situations stock was in the team’s favour. At the time, the share price had taken a hammering as cancer patients claimed the fertiliser Roundup was carcinogenic. Bayer acquired the stock as part of its $63bn acquisition of Monsanto.
The market was pricing in a $35bn payout from the resulting litigation, according to Clay, but reports of an out-of-court settlement in the summer suggested the liability would be closer to $8bn. The holding represents 2.9% of the fund.
BNY Mellon Investment Management doesn’t comment on holdings outside the top 10 but Clay says retailers are a sector he’s been adding to during the past 12 months, as the market worries about online disruption, a potential recession and a slowdown from Chinese consumers. All these are in the price, he argues.
“If your valuation in a defensive stock is very high, then you are only going to continue to make money from those defensive stocks if they deliver perfection,” he says. “Whereas most of these consumer cyclical stocks are already pricing in quite a material slowdown in their industry, and some even a recession. So, we would argue the asymmetry of risk/reward is skewed in your favour.”
Why Diageo is out of the portfolio
The black and white parameters of the fund’s investible universe counters potential behavioural bias in the team, claims Clay, who says he came to terms with his own fallibility as an investor after reading James Montier’s book, Behavioural Investing, several times over.
“Invariably we are told we are idiots when we are buying things and idiots when we are selling things. Left to our own devices, as human beings we probably wouldn’t do this,” he says of the fund’s buy-and-sell strategy.
Diageo is an example of a stock sold by the fund recently just as market consensus moved in favour of the drinks business. Without the sell discipline, Clay doesn’t believe he would have sold the stock.
“Everybody loves Diageo,” Clay says, pointing to the fact that whisky is recession proof and the company has plenty of room to grow in India and China. “All of that is true, but it is already in the share price. In order for you to continue making good money on Diageo from today’s share price, we’d have to have a very deep recession, for people to keep paying up for high-end whisky and for the Chinese and the Indian markets to start opening up to them.”
After four years in the portfolio, Diageo was shed between Q1 and Q2 2019. All disposals must remain at market-level yields or lower for 30 days before any selling takes place. Due to the £9.7bn Clay runs across strategies, disposals take place over a six-month period so that trades don’t move the market. It also provides ample time for the team to find a competing idea, with company analysis typically taking three months.
Even if a stock exits the portfolio due to a dividend cut, the process is helpful as 80% of the share price gains after the market reacts happen in the first six months, according to Clay. Of the 11 stocks that were unloaded because of dividend cuts since 2010, eight rebounded after six months while four had done so after 12 months, which Clay says vindicates his team’s approach.
Mattel is one such stock the team was forced to sell due to a dividend cut in Q4 2017, as part of a $650m cost-cutting exercise. Rival toymaker Hasbro was outperforming at the time but, based on historical data, the team expected this relationship to revert to mean and for Mattel to return to a period of outperformance.
Says Clay: “Because it took longer to mean-revert than it should have done, the debts in Mattel became too much to bear and they were forced to cut the dividends in order to continue paying the debt.”
The investible universe “changes a lot with the ebb and flow of what’s leading the market at the time” but has some stable constituents, such as industrials, miners, oil majors and banks.
“At the moment, we could buy all of those because they are yielding enough, but we choose not to because of where we are in the economic cycle.”
Consumer goods are the largest overweight, at 12.5% above the index, while financial and industrials are the biggest underweights, at 8.1% and 7.9% below the index, respectively. All regions bar Japan have been an overweight at some point in time.
Quantitative easing has turned markets into Pavlov’s dogs
Clay does not predict quantitative easing (QE) in its current form will continue much longer, as politicians and even central bankers highlighting that labour will become the new beneficiary of stimulus over capital. But markets haven’t yet cottoned on and continue to salivate “like Pavlov’s dogs” on bad news as they anticipate central bank support.
Clay points to Fed chair Jerome Powell’s pivot in January after the Q4 sell-off of 2018 as an example of why markets react to bad news the way they do. The fund fell by 7.9% during Q4 2018, short of the 11% losses felt in the FTSE World. In the month’s following Powell’s speech, the fund rose 3.1%, compared to 1.9% in the benchmark.
Of course, Clay believes BNY Mellon Global Income will outperform if his hypothesis proves correct and stimulus shifts away from capital, thanks to the 50% of the fund’s total return coming from compounding income.
“In the longer-term history of markets, from 1970 to last year, the biggest driver of returns is the compounding of a dividend and its growth in that dividend, which is completely at odds with what’s driven the market for the past 10 years because of QE.
“This is the aberration, we are just going to revert to a more normal environment.”
Wealth manager view – Justine Fearns Research manager, Chase de Vere
The BNY Mellon Global Income Fund has been in existence since November 2005, and since that date it has outperformed its benchmark, delivering a high level of income with a few changes along the way.
The fund is framed, as is every fund in the formerly named Newton stable, by high-level investment themes, which help steer the investment analysts and fund managers in stock analysis and portfolio construction.
Everyone has a clear role to play in the investment process but it is very much a team approach, which has been consistently applied over time and is a major strength underpinning the fund.
This fund is run by Nick Clay, who has been a member of the global equity team since 2012, and his knowledge is now utilised throughout the firm in a number of internal investment groups. Suffice to say, the fund is in a safe pair of hands.
