Fund in Focus: Election Special

Fund in Focus: Election Special - 5th July 2024

[00:00:00] Nick Peters: Hi, welcome to this week's podcast. My name's Nick Peters, investment advisor at Marlborough and for this election special podcast we're joined by Eustace Santa Barbara, fund manager for Marlborough Special Situations Fund. Hi Eustace.

[00:00:22] Eustace Santa Barbara: Hi Nick.

[00:00:23] Nick Peters: So let's get straight to it, the election result was very much as people forecast with a strong majority for the Labour Party, can you explain to listeners how you feel their policies could help the stock market?

[00:00:35] Eustace Santa Barbara: Absolutely, Nick. I mean, you're right to flag that it's a strong majority for the Labour Party today. Prior to today, the highest ever number of seats won by a Labour Party was 418. This happened in 1997, in the general election when the Labour Party was led by Tony Blair.

[00:00:52] Eustace Santa Barbara: On the flip side, the Conservative Party was formally established in 1834, and prior to today, the fewest number of seats they had ever won in a general election, was 156, which occurred in 1906.

[00:01:06] Eustace Santa Barbara: So despite those results today, as you correctly identify, Nick, the latest polls and even the latest MRP method of polling's, which is multi-level regression and post ratification, they predicted the outcome accordingly.

[00:01:21] Eustace Santa Barbara: So you might say, well, what does a large majority for the Labour Party mean?

[00:01:25] Eustace Santa Barbara: Well, on the one hand, it could allow Labour to enact more radical policies, or it could allow its leader to ignore the more left views in the party and adopt a more centrist stance.

[00:01:36] Eustace Santa Barbara: When you look back over the last 14 years of conservative leadership, they've arguably been quite interventionalist. Schemes such as help to buy, the introduction of energy price caps, and a very punitive and often haphazard tax policy for oil and gas companies in the North Sea.

[00:01:55] Eustace Santa Barbara: Rachel Reeves has done a good job up to this point of portraying a more business friendly type approach and she also likely understands the importance of being economically responsible and focusing on long-term growth as opposed to pledging more material changes to spending or fiscal rules. It will probably be though until the autumn budget that we have to wait to understand more.

[00:02:20] Eustace Santa Barbara: I would say today's result shows that stability may well be the order of the day, especially post a particularly tumultuous 2022 in the UK, which as we all know saw three different prime ministers and four different chancellors of the exchequer.

[00:02:36] Eustace Santa Barbara: Turning to the economy, we have three pieces. We have accelerating growth, we have lower inflation, and we have the likelihood of lower interest rates. So, the GDP data for Q1 in the UK was 0.7%, and GDP is forecast to grow in the UK at around a 2% clip.

[00:02:54] Eustace Santa Barbara: The Bank of England may well cut the base rate, or the interest rate, on August 1st, and markets area scribing a 50% chance of a rate cut right now.

[00:03:03] Eustace Santa Barbara: It seems a while ago that CPI was 11.1%, which was October 2022, and the latest CPI print, or Consumer Price Inflation print, for May 2024 reported at 2%, the Bank of England's base rate target.

[00:03:17] Eustace Santa Barbara: On the other hand, in all likelihood, taxes will either be maintained or increase. Labour's manifesto has committed not to increase VAT, or income tax, or national insurance, though details at this point are quite scant in other areas of potential taxation, including capital gains tax, inheritance tax, and the tax treatment of pensions.

[00:03:39] Eustace Santa Barbara: There are four areas I wanted to touch on, Nick, in regards to where I think Labour could be spending some of their monies to try and adhere to what they've articulated in their manifesto. So I'd like to talk about national infrastructure, housing, defence, and the NHS.

[00:03:58] Eustace Santa Barbara: So in national infrastructure and rejuvenating that, one really has to look at things like hospitals, schools, transport, and stocks that could be pronounced beneficiaries from additional spend in these areas often trade at attractive valuations.

[00:04:12] Eustace Santa Barbara: So I'm talking about names in the support services sector, construction names, consultancy names, or equipment hire companies.

[00:04:20] Eustace Santa Barbara: Now at the same time, when one considers national infrastructure, risks do exist around those public entities that could come up against new entities created by Labour.

[00:04:29] Eustace Santa Barbara: And here I'm talking about things such as the Great British Railways, which could supplant private companies contracts upon expiry and Great British Energy, which is a newly publicly owned energy generation company.

[00:04:42] Eustace Santa Barbara: And then finally, you have to consider the well documented malaise afflicting the UK's water industry and investment, which could also come up against regulatory changes or indeed political interventions.

[00:04:53] Eustace Santa Barbara: Now the good news on the bigger elements, the Great British Railways, Great British Energy and the UK's water industry, is there are not a lot of UK small and mid-cap companies that operate in that space.

[00:05:04] Eustace Santa Barbara: I'll turn now to housing, where, again, in the manifesto, the Labour Party has talked about amendments to the planning system, this is something that the Conservatives did talk about, although it was very difficult to attain.

[00:05:15] Eustace Santa Barbara: Labour could indeed institute direct incentives to housebuilders, and really you'd be looking at affordable mixed tenure homes, but other beneficiaries could be brick manufacturers and building materials companies.

[00:05:26] Eustace Santa Barbara: In terms of defence, given the ongoing geopolitical instability, Labour have promised to increase UK defence spending to 2.5% of GDP, although the timeline of that is uncertain, and all they've said is quote unquote "As soon as resources allow." Now there are some very large companies in the UK that operate in the defence space, but there are also a handful of small and mid cap defence names that could be beneficiaries of increased spend here.

[00:05:52] Eustace Santa Barbara: Finally, in terms of the NHS, increased investment in the NHS has been pledged and that could boost drug makers, medical device manufacturers, but also private healthcare providers who collaborate with consultants. This may be seen as ideologically challenging, though I would argue it could be a pragmatic manner in which to reduce the long-standing problem of waiting lists.

[00:06:15] Eustace Santa Barbara: So I hope that gives our listeners an idea about the outcome of the election, how the economy is, and some of the key sectors that have been identified in the Labour manifesto that could be beneficiaries of increased spend.

[00:06:27] Nick Peters: That's excellent, thanks for that, yeah, as you say, you've highlighted a few areas that could benefit. Will you have positioned or tweaked the portfolio towards those sectors or industries already?

[00:06:39] Eustace Santa Barbara: I'm glad you said the word tweak, Nick, because essentially we are not going to wholesale shift our portfolio based on an election result, especially one that has been pretty well telegraphed in terms of the outcome.

[00:06:51] Eustace Santa Barbara: I do not think today's outcome was unexpected, and as such, we're obviously attuned to those little nuances that can emerge in the coming weeks and certainly in the autumn budget, but broadly speaking, it's more tweaks or evolutions as opposed to revolution of the funds.

[00:07:10] Eustace Santa Barbara: The other thing I'd say, Nick, is that in terms of markets in general, both parties have talked about encouraging saving and investing.

[00:07:16] Eustace Santa Barbara: Both parties, for example, have discussed a GB ISA. I was reading some research from the investment platform AJ Bell, and they undertook a study of all the 16 general elections that have occurred since the FTSE All-share was established in 1962. And on average, the FTSE All-share recorded a double digit percentage gain in the first year after an election, which sees one prime minister ejected from office and another new one ushered into it.

[00:07:43] Eustace Santa Barbara: And the other interesting thing to note is that how big a majority a new leader has, has had historically very little impact on the resulting returns.

[00:07:52] Nick Peters: Yeah, Marlborough have done similar research and come to similar conclusions on the size of a majority, and just taking the discussion more broadly and looking at the deeper dive on Marlborough special situations, performance has picked up of late, which is obviously great to see.

[00:08:08] Nick Peters: What do you put that down to?

[00:08:10] Eustace Santa Barbara: Three things, Nick. The first would be M&A, increased merger and acquisition activity. Secondly, we've seen a general recovery of names across the fund and then thirdly, we've actually had a little cherry on cakes with regards to some okay IPOs (Initial Public Offering*) as well. Let me take each one of those in turn.

[00:08:27] Eustace Santa Barbara: M&A in quarter one,2024 exceeded 10 billion pounds in the UK, and that was the second highest quarter since 2000, we've been the beneficiary of four takeovers in that period. So communications equipment and network testing company, Spirent Communications, pension consultancy and wealth management services business, Mattioli Woods, a self storage company based in the UK called Lock and Store and then finally, a professional services business called Alpha Financial Markets Consulting.

[00:08:57] Eustace Santa Barbara: So that's the M&A piece in terms of the general recovery of names across the fund, I was looking at the top 10 positions, which make up 21% of the fund, and they're up an average of 30% over the last six months.

[00:09:11] Eustace Santa Barbara: I then looked at the next 10 positions in the fund, they make up a further 14% of the fund, and they're up an average of 19% over the last six months.

[00:09:22] Eustace Santa Barbara: And then finally, in terms of IPOs, I think the pipeline's looking healthy, capital markets, the mood seems to be improving.

[00:09:29] Eustace Santa Barbara: But we had a notable company called Raspberry Pi, this is a Cambridge based computer company, which listed on the FTSE 250 in June with a valuation of over £500 million and in its short life thus far on the exchange, the shares have performed well.

[00:09:44] Nick Peters: Thank you. We've been arguing for a while that UK stocks, especially smaller company stocks, are looking very good value and the pickup in M&A serves to sort of reinforce that message.

[00:09:56] Nick Peters: As you say, we've seen a pickup in performance, but on your metrics, just how cheap are smaller companies right now?

[00:10:03] Eustace Santa Barbara: Well, you're right to flag Nick that this has been an ongoing commentary from many people in the UK small and mid cap for the last two years. But despite the outperformance over the last six months on a relative basis, the valuation anomaly in my view still exists.

[00:10:17] Eustace Santa Barbara: So UK smaller companies that are a material discount probably 15% to UK larger companies, and as we know, the UK market as a whole is on a very significant discount to global equities.

[00:10:29] Eustace Santa Barbara: So from my perspective, this remains a very attractive entry point with our space on an absolute basis, on a relative basis versus other developed market equities, and relative to its own history.

[00:10:41] Eustace Santa Barbara: After a long or prolonged period of extremely negative sentiment towards the space and outflows, just a small improvement, I would argue, could have an outsized result.

[00:10:52] Nick Peters: And then looking at the sort of stocks that you invest in, and many of them have structural growth drivers that actually should boost a company's growth, irrespective of interest rates, general elections, majorities, in your fund, you describe them as steady compounders, can you perhaps give listeners a couple of examples of those?

[00:11:12] Eustace Santa Barbara: So one example would be Cranswick, which has a market cap of about £2.4 billion. This is a leading UK food producer producing and supplying premium food to UK grocery retailers.

[00:11:24] Eustace Santa Barbara: Its heritage is in fresh pork. It's 50 years in fresh pork, so it started in the mid 1974, though it recently, and by recently I mean in 2016, it entered the poultry market.

[00:11:35] Eustace Santa Barbara: It's a vertically integrated business model, so everything from feed milling, it owns farms, it is a primary processor of the animals, and then sells to the end customer, which is, as I said, can be retail, but also wholesale food service and export.

[00:11:49] Eustace Santa Barbara: And it's got a very exemplary track record, five year compound annual growth rate, it's grown its revenue 10% over the last five years, it's grown its EPS on a compound annual growth rate of 8% and it's dividend per share over that same period of 8%.

[00:12:04] Eustace Santa Barbara: It's a consistent mid-teens return on capital employed business, so the capital it deploys generates a significant return, and when you consider that type of business, It's trading at a high single percentage discount to its long run average at about a 17 times one year forward price to earnings ratio, I would call that an attractive business that is still being underappreciated in a market.

[00:12:26] Eustace Santa Barbara: So that's one example and then the second example, I'd probably give you Nick is a business called Alpha Group International, which has a market cap of around £930 million. What this business does, it provides financial solutions to corporates and institutions operating internationally and there are two segments.

[00:12:43] Eustace Santa Barbara: The first is foreign exchange management, so hedges and swaps for business entities. The second is alternative banking solutions, which offers local accounts to investment vehicles, which might be private equity, private debt, venture capital, or infrastructure funds.

[00:12:58] Eustace Santa Barbara: Now what makes Alpha Group International special is it provides a more tailored solution versus say a large investment bank and it is still benefiting from the unbundling of the banking value chain.

[00:13:09] Eustace Santa Barbara: Over a quarter of its market cap is in net cash and that cash balance is only growing through interest earned and cash generation. The free cashflow yield of this business still remains in its low teens which I would call attractive. It's engaged in its second share buyback so the company thinks its shares are inexpensive and therefore is buying back those shares and retiring them.

[00:13:29] Eustace Santa Barbara: And again, it trades at a small discount to its long run average, trading on about a 22 times one year forward PE, a very good business that I think is again, being underestimated by the market in today's environment.

[00:13:42] Nick Peters: Excellent. Thank you, Eustace. That's been a really great catch up, thanks very much for your time.

[00:13:47] Eustace Santa Barbara: Thanks for having me Nick.

[00:13:49] Nick Peters: That was Eustace Santa Barbara, the fund manager for Marlborough's Special Situations Fund, and please go to our website if you'd like to find out more information about the fund. Thank you very much for your time and goodbye.

*IPO - Initial Public Offering: An initial public offering (IPO) or stock launch is  in which shares of a company are sold to investors.

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This article is provided for general information purposes only and should not be construed as personal financial advice to invest in any fund or product. These are the investment manager’s views at the time of writing and should not be construed as investment advice. The opinions expressed are correct at time of writing and may be subject to change. Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.