Reflationary environment to reverse market ‘worship’ of defensiveness, say Man GLG’s Dixon and Barrat

The post-Trump reflationary environment could provide a tailwind for domestically focused UK equity managers, say Man GLG’s UK equity duo Henry Dixon and Jack Barrat.
Dixon and Barrat, who have co-managed the £504m Man GLG Undervalued Assets fund since launch in November 2013, say that with inflation set to rise and bond yields backing up following the victory of President-elect Trump in the US, the market could be set to return to a world in which valuations and balance sheets are no longer of secondary importance to yield-hungry investors.
“Not only do bond-proxies appear expensive, they appear expensive on margin highs, with record debt and distributing a record amount of cashflow,” says Dixon. “The justification for these high valuations has been the read-across from the bond-market, where yields have fallen sharply in recent years. But with the bond sell-off gathering pace, there is a good possibility that the market will stop worshipping defensiveness and ignoring balance sheets and focus instead on the price paid for stocks.”
While bond proxies have delivered above average returns compared to peers in the UK over the last three years, many of them funded dividend growth via debt. Now, with bond markets changing direction and inflation returning, many look vulnerable, with share prices down sharply in recent days.
“If inflation was to return it would call into question the dominant market narrative that we have moved beyond a cycle with interest rates lower forever. The risk-reward of being in expensive areas in the market priced for a perpetuation of a historically extreme status quo doesn’t seem attractive to us. Especially as the weight of historical evidence supports the prevalence of cycles over time,” says Barrat.
“The key differentiating factor we are looking to own is valuation and pricing power,” says Dixon. “We believe the ability to respond to an inflationary environment by putting up prices is absolutely crucial to performance. We are looking for companies combining that with a sensible starting valuation, well managed cost base and a strong balance sheet.”
In terms of stocks the Man GLG Undervalued Assets Fund is focusing on, Barrat highlights the need to look through currency related upgrades to positive underlying operating performance when analysing overseas earners. “As we’ve seen with more cautious recent updates from Laird, Senior, NCC and Keller simply buying US dollar earners can be dangerous. We try to isolate underlying momentum which can be augmented by any move down in sterling.” The fund has added to positions in recruiter Hays, interdealer broker Tullett Prebon and speciality chemicals firm Synthomer.
The fund – which has returned 21.5% (net of fees) since launch in November 2013^[1], versus the IA UK All Companies sector average return of 14.39%^[2] putting it in the 1st quartile of its peer group – is also looking for opportunities domestically, with an increase in spending by the government a possibility to offset weak growth. As such, the managers have invested in stocks exposed to the 4H’s of Hinkley, Heathrow, Highways and Housing, via stocks including Watkin Jones (the constructor of student and private rental accommodation) and Costain (a UK-focused construction firm).
The managers say their domestic positioning could prove advantageous in an environment where sterling could rally after reaching a low which has left it cheaper on a purchasing power parity basis than it was following either the Lehman Brothers collapse or the withdrawal from the ERM in 1992.
“The FTSE 100 has a lot of dollar earners that have all benefitted from a weak sterling and strong dollar,” says Barrat. “Given our domestic exposure and lack of ownership of names like Royal Dutch Shell, we would expect to benefit from a stronger sterling environment, although it’s not our job to forecast currency movements.”
More broadly, Dixon adds that, while the operating environment for the fund has been difficult since its launch in 2013, the shift in backdrop should provide a tailwind for their process. “Bond yields have more than halved since our launch and this has to some extent undermined the two key pillars of the process,” he says. “However, we are ever hopeful of a more normalised bond yield environment and are excited to see how well the fund can perform in a world in which valuations and balance sheets once again become important.”
[1] 0.75% management fee has been applied. Past performance is not indicative of future results.
[2] According to Lipper, the Man GLG Undervalued Assets Professional Acc C GBP has delivered 21.5% since launch in 15/11/2013 to 11/11/2016, versus the IA UK All Companies NR of 14.39%.