A professional investor tells MoneyWeek where he’d put his money now. This week: John Wood, senior fund manager, JOHCM UK Opportunities fund
The big question investors should be asking right now is: where are we in the corporate profitability cycle? Although we can’t be certain as yet, many analysts think that corporate profitability may have peaked. This means we are reaching a point where merger and acquisition activity – whether by infrastructure funds, private equity or other quoted companies – could be destroying value. Low interest rates have allowed the market to overlook this as deals raise earnings. The market has become very short-termist, focusing on where the next deal might come from, without thinking about expected returns on investment. Relative valuations have helped drive prices higher across sectors. This could last for some time if debt stays cheap and private equity firms remain under pressure to invest their funds.
This is a perfectly normal stage in the cycle, but it does affect how we have to think about the risks and rewards of investing. Valuation measures such as free cash flow yield, return on capital employed and discounted cash flow must be used to make sure that shares are not overvalued on a fundamental basis. We spend as much time trying to avoid losers as we do identifying winners. We prefer firms in secular (long-term) growth areas, rather than ones which are more sensitive to interest rates and the economic cycle. This makes it more likely that management will create value through reinvestment.
On this basis, over the summer we sold out of cyclicals such as global advertising group WPP (WPP) and building products and car parts giant Tomkins (TOMK). We have instead bought stocks with attractively valued secular earnings, such as defence electronics group Cobham (COB) and Bunzl (BNZL), which is a business-to-business distributor of consumables such as plastic plates. In particular, we have been looking for companies that are prepared to invest on a longer-term time horizon (to us that means two to four years), even if it means current profits take a hit. Good examples are Arriva (ARI), which has secured a number of rail and bus contracts in continental Europe, and Scottish & Southern Energy (SSE), which is aiming to aggressively grow its customer base by not passing on the full increases in wholesale gas and electricity prices, and always ensuring that when it does lift prices that it is the last to do so.
Another area of interest is the savings market, which is replacing unsecured credit as the key driver of high-street bank earnings growth. Analysis was needed to see whether this shift was more pronounced in certain parts of the population, and how best to gain exposure. As a result of that analysis, we recently added HBOS (HBOS) to our portfolio to complement our holdings in the life insurance sector.
Throughout this year, our fund has done well out of its large holdings in utilities such as Scottish & Southern, AWG and BAA. Unlike many fund managers, I actually like utilities. I look for companies with what I call recurring revenue business models. With utilities, the regulators tell you what the sales line is going to be for a period of five years, as well as the amount of capital to be reinvested. This consistency is one reason why they are so attractive to infrastructure funds just now.