Temporary Impacts and Permanent Shifts
Tideway Market Update, 25th September 2020

James Baxter

2020 has been and will continue to be a year of unprecedented change, that is for sure.

As long-term investors, a key challenge for both ourselves and our fund managers has been sifting through these changes and looking at those which will likely only have a short-term impact versus those changes that are going to have much more lasting impact on investment markets.

Here are some of the things we consider will likely have a lasting impact.

Low Interest Rates

It appears the Bank of England have been looking at how they might use negative rates as a stimulus tool. The Governor was quick to deny that this was an imminent plan, but clearly it is being considered.

Last week saw NS&I drop rates on savings accounts and pay outs on Premium Bonds. On its popular Income Bonds it cut interest from 1.15% to 0.01%. That’s no interest in my book, if you now want absolute security on your cash deposit there is now no return available, and we don’t see this changing in the short term.

20-year rates are off their lowest but still only 0.7%. Price to earnings (PE) ratios: the price paid divided by the income receivable are often used to value investment assets. A company worth £1billion generating £40million a year in profits would have a PE ratio of 25, a £1m house generating £30,000 pa in rents would have a PE ratio of 33. These are the sort of numbers we have become accustom to in recent years. The PE ratio on a 20-year gilt in 2000 was 20, it’s now 142!

“So what?” you might ask. Well the PE on risk free gilts are a benchmark against which other assets get compared. What additional return do you need to take some risk? Against a risk-free PE ratio of 20 you would want PE’s on riskier assets to be sub 20. To be sub 142, there is plenty of scope for riskier assets to go up in value from current prices and still be worth the risk. 

Peak Oil

Last week BP produced a scenario analysis where oil demand had peaked already in 2019. The term ‘peak oil’ was first used in an around 2006/7 when analysts were predicting that the ability of the world’s oil companies to supply oil would soon peak against a back drop of rising demand. In May 2008 the mighty Goldman Sachs predicted oil prices, having already reached $140 a barrel, would spike to $200 a barrel. Within a year and in the wake of the great financial crisis it would be down to $40 a barrel, roughly where it stands today.  Goldman’s are still bullish on oil prices today (more bullish than BP), but no one is predicting demand outstripping supply anymore.  

That BP consider a scenario where demand may have already peaked is a huge turnaround from predictions, they were making just 2 years ago.  Where oil companies like BP could ‘talk the talk’ about shifts to green energy in the 90’s and 00’s, whilst at the same time increasing oil production, market forces now make this shift an imperative.  BP’s share price has halved in the last two years and is at a level first reached in 1995, 25 years ago.  Its mighty dividend has been cut in half and it is rapidly devaluing its oil reserves with the increasing likelihood that a lot of the oil and gas reserves it owns will likely stay underground. The new CEO is making some very bold statements as to the future of BP and the pace with which BP shifts to alternative energy and cuts oil production will be fascinating both for future investment return opportunities and from an ethical and climate change perspective. 

And one change which we think may be more temporary.

Property and Property Funds

There is clearly a big shock to some sectors of the commercial property market with empty city offices and retail parks and centres.   But is property likely to be over for a long time as a good investment, we are not convinced.  The market is dynamic and whilst demand may shift around the overall demand for a roof over your head, whether that’s to live in or operate a business from is unlikely to be diminished. The PE argument applies to property as much as shares and buildings with strong tenants and decent yields will hold and likely increase in value in a zero-interest rate world.  

One issue which has been in the news in recent weeks is the closing or shuttering of open ended property funds which have had to lock-in investors where there have been too many redemption requests and not enough cash, and selling properties has been impossible during the lock down.  This has highlighted an issue which has always been present in these funds which offer daily liquidity to investors but then invest in what at times can be highly illiquid buildings.

The FCA has eventually sought to investigate this and is suggesting six-month notice periods on such funds. We think that’s a sticking plaster on a serious underlying problem.

How are Tideway Portfolios Positioned Around These Views?
Nick Gait

Oils and Energy:

Our exposure to the energy sector is below benchmark, particularly when consideration is given to the fixed income element of your portfolio where neither the Sanlam Credit nor Sanlam Hybrid Capital Bond Fund has any direct exposure to the sector.

In terms of exposure in the equity book, Unicorn have never invested in the sector as they do not believe they have an advantage in this area, preferring to focus on sectors with more stable cashflows and better dividend coverage. Heriot Global also has no direct exposure to the energy sector after selling their last remaining holding prior to 2020 whilst investing in the energy sector has never been a part of Lindsell Train’s investment process which focuses on quality companies with barriers to entry.

Most of our exposure to the sector comes through our more value orientated funds such as Schroder Global Equity Income and Artemis Global Income. Artemis Global Income has been reducing their exposure for just over a year with an overall allocation of just 3.2% at the end of July compared to 10.8% one year prior. As you may have read from our previous communications, Schroder Global Equity Income, as a value manager, often takes contrarian bets based on companies trading below their intrinsic value. As a reminder the team will conduct extensive fundamental analysis on all companies, they invest in often going months on end without making an investment if the price is not right. 

To avoid value traps, the team will amongst other things assess both ESG and structural challenges facing the wider industry and incorporate these risks into the discount rate used to value the company. The higher the discount rate as a result of these risks will mean they require a lower price than they otherwise would to maintain their margin of safety. The fund has a 6.8% allocation to the sector as of end of June with highest exposure being in Eni, an Italian multinational oil and gas company. Blackrock Emerging Markets is also slightly overweight it’s benchmark, though due to the team’s investment process and with a portfolio turnover of 100% in any given year, this will likely vary considerably over time.

Property:

According to the Financial Times there is roughly £22bn of investor money tied up in UK commercial property funds. After closing in March only a handful of the major participants have lifted the restrictions on their funds and allowed investors access to their money due to fears of investors immediately depleting cash reserves by demanding access to their money.

As a firm, we have always felt that open ended property funds are not fit for purpose due to the inherent liquidity mismatch; the daily liquidity requirements of an open ended UCITS fund to the relatively illiquid property that is being invested in. This relatively simple analysis aside, investors were given a warning of this mismatch in 2016 when a number of high-profile UK property funds had to gate temporarily until the cash being asked for by investors could be raised.

Tideway also has exposure to the Real Estate sector through Schroder Global Cities Real Estate (we have talked about this fund in more detail in a previous communication) that invests in Real Estate Investment Trust (REIT) securities. These trade on exchange like listed equities and therefore cash proceeds can be easily realised when needed. The obvious drawback to this more liquid strategy is that the fund is much more highly correlated to wider equity markets, especially in times of market stress. We much prefer less diversification over the short term than for our investors to be unable to access their monies for an unknown period. We would anticipate that when these funds do return cash to investors, much of it will go into the listed Real Estate space.

Gilts and Fixed Income:  

As a reminder Tideway have long held the view that at low rates government securities are not worth holding particularly after inflation and fees. In their monthly Asset Allocation piece, TS Lombard, have stated that the case for holding governments is waning and have reduced their holding due to both reduced income and reduced diversification benefits. For us the latter point is most significant, and casts doubt over the usefulness in any portfolio.

TS Lombard’s analysis is comforting to hear and reaffirms our position of not holding government securities and our overweight position in Credit through Sanlam, Artemis and Royal London managed funds. Again, with a period of low to zero rates looking very likely, we expect other investors to follow suit.

Our “Low Risk Bond” portfolio which contains Short Duration Credit offerings from Sanlam and Royal London as well as a corporate bond strategy from Artemis is currently yielding 3.22%. Although not “risk free” like securities issued by the government we have faith in our managers to manage risk carefully by avoiding companies likely to default on their obligations and to limit drawdowns in normal market conditions.

Have a good weekend,
The Tideway Team

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Tideway Investment Group comprises the following entities: Tideway Investment Partners LLP and Tideway Wealth Management Limited. Tideway Wealth Management Limited is an appointed representative of Tideway Investment Partners LLP, which is authorised and regulated by the Financial Conduct Authority. FCA number: 496214.

Tideway Wealth Management Ltd
107 Leadenhall Street
London EC3A 4AF

+44 (0)20 3143 6100
info@tidewayinvestment.co.uk

© Tideway Investment Group 2020

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