2nd February 2014
Last week Invesco Perpetual ran an webcast interview with Mark Barnett, the fund manager due to take over Neil Woodford’s Income and High Income funds and the Edinburgh Investment Trust.
The interview was conducted by journalist Paul Burden mostly putting questions emailed in from financial advisers.
At Mindful Money, while we certainly feel that Mr Barnett’s macro-economic views are clearly important (and we include a lot of those questions and answers at the end of this article) we feel that the three most important questions asked involved his view on diversification of his portfolios, his view on how he will manage the transition and how he will cope with potential redemptions.
So for the first three questions and answers, we asked Chelsea Financial Services MD and Mindful Money contributor Darius McDermott to give us his analysis on Mr Barnett’s answers (in bold below).
Q: How is the transition progressing and what sort of things are happening during the process?”
Mark Barnett: The transition is progressing well. You may have seen that we were appointed to continue to manage the Edinburgh Investment Trust – it was on the Stock Exchange yesterday – which is a very big and important announcement and I think is, from my perspective, a validation of what I’m trying to do in terms of how I’m going to be proceeding with the management of the funds going forward. So, frankly, things are just fine. I’m not actually managing the big funds yet. That won’t happen till the end of April, when Neil leaves the company, so the actual day-to-day management of those funds is being handled by Neil.
But I’m taking over team responsibilities, which is a new area for me – I haven’t done that before – in terms of making sure the appraisals are all done etc, and there is some recruitment going on in one or two areas. So, that’s something that I’m occupying my time with, as well as, obviously, looking at a selection of companies that I haven’t looked at before – some new companies which I don’t own in my funds, which I will be inheriting, particularly smaller ones – quoted and unquoted – that I’m using the time now, in the transition, to get more familiar with as investment prospects.
Darius McDermott’s view:
“Mark is a good, experienced manager and has a very similar style to Neil. In any other circumstance you would have complete faith in his ability to do well for investors. However, I have to say that taking on the two equity income funds and the Edinburgh Investment Trust is a big enough job in itself, on top of the funds Mark already manages himself, let alone taking on team responsibilities and all the things that come with that. He’s mentioned appraisals and having to recruit more people – I think it’s just too much to ask one man to do and in the short term I would be much happier if someone else took on the team roles and let Mark concentrate on client money. I’d like him focused on on the funds without any other distractions at all and I’m sure other investors feel the same. I think even the number of funds he is running should be monitored carefully and perhaps one or two being entrusted to other members of the team.”
Q: How can you handle such a large amount of money’ – we’re talking about a very significant sum here – ‘and so many funds, including your existing responsibilities?’
Mark Barnett: “My existing responsibilities are going to remain on the funds that I’ve managed historically – the three investment trusts and one open-ended fund, Strategic Income. My style has always been to see myself as a long-term investor and, clearly, with much larger sums of money, that’s reinforced in that you can’t make decisions to swing funds about easily or quickly, so you have to take views that will last and where you’ll be supporting businesses over the long term. In fact, the turnover on my funds historically has been low, which is reflective of the fact that my average holding period has been four to five years, and that’s been the same for a number of years now. So, I would suggest strongly that my approach and style and philosophy lend itself to larger sums of money. The honest answer is, to be fair, I haven’t done it before, so I don’t know and, therefore, ask me the same question in a year’s time and I’ll be able to give you a much better answer, but my belief is that my process is scalable to larger sums of money.
“And importantly, bear in mind I’m not doing it on my own. There is a team around me. There is a team of dealers that are very experienced on dealing on these funds, have worked in the company for many, many years, and they will be helping me to facilitate the trades and make the transition and make the changes that I want to make. But also, on the UK team itself, we are a team of seven people on the large cap, three people on the small cap side, both fund managers and trainee fund managers, and we do share ideas, share research, share analysis, so, in that sense, I’m not on my own, in my office, tucked away. I’ll be benefiting from the expertise and analysis of my colleagues, and that’s an important component to bear in mind when thinking about managing these funds.”
Q: How will you manage any outflows which might arise?’
Mark Barnett: Well, at the moment, the outflows, because Neil is still managing the funds, are being handled by him. My stance will be to try, very much in the same way that he has done, effect the changes or fund the redemptions in a way which is unpredictable and trying to be as anonymous as possible. You want to stay under the radar. You don’t want to make the changes where the market can see you coming, both on the sells and the buys, because the redemptions part of what I can use the redemptions for is to try to reshape the fund in a way that I want to see it. But you want to do it in a way that is unanticipated, because the last thing you want to do is to sell into a market which can see you coming. So, I have plans – I have thoughts about what I’m going to do, but I’ll reserve the right not to disclose those at this point in time, until I’ve started to make the changes.
Darius McDermott: “Mark, and indeed Invesco Perpetual as a whole are obviously thinking very hard about outflows and how to mange them properly and protect existing investors and I think they way they say they are going about it is the right way to go. My only word of caution is that I hope the plans are robust enough to deal with what could be a considerable increase in outflows once people know exactly what Neil’s plans are. If he’s launching a similar fund as soon as he leaves, then people are bound to follow him and I expect to see more movement than we have up to now. What we all want to avoid is investors, who would otherwise remain with Mark, panicking. It’s a difficult one to manage in many respects.
“Selling the tail of the fund could be challenging too as some of these holdings are likely to be smaller companies and possibly unlisted ones. I think the outflows could be damaging to performance in the short-term. No matter how good a manager you are, you can’t do your best if you are constantly having to sell holdings rather than buy ones you like.”
Q: An analysis of your stock holdings would suggest that you give more emphasis to diversification. Now, is that a fair comment?
Mark Barnett: I think that my funds have historically had holdings of around 60 to 80, which is sufficiently diversified. A fairly concentrated list, so that, actually, the top 10 tends to represent between 40% and 45% of the fund, and the next 10 would be another 20 or 25. So, the top 20 would be maybe 60% to 70%, and then, thereafter, there’s a tail. I’ve long tended to monitor what I would call the tail of holdings, represented by everything that’s 0.5% or less in the portfolio. I’ve tended to monitor that quite closely, so that I will constantly reappraise the rationale for holding lots of smaller holdings at that end of the portfolio, because that can often distract and take time away from me concentrating on the bigger positions in the fund. So, my approach has tended to be probably fairly diversified in terms of total holdings, concentrated but not overly concentrated, and with a strong emphasis on making sure that, if something is in the section called the tail of the portfolio, it is definitely there for the right reason and it represents the good risk-reward trade-off that I think is appropriate for certain companies that should be in that part of the portfolio.
Darius McDermott: “Mark’s style and portfolios have very similar characteristics to Neil. The main difference, as he mentions, is having more diversification. This is evidenced to some extent by the fact that while Mark like pharmaceuticals, he is much less overweight this sector than Neil, who has had more of a major call on this area.”
These are the rest of the questions.
Q: ‘Should we expect to see any changes to the approach, structure or management of the UK Strategic Income Fund?’
Mark Barnett: No. I will be managing the Strategic Income Fund going forward. That is a fund that I’ve managed for the last eight years. If you want an example of what a fund looks like that I have managed for a long period of time, that’s an ICVC that I’ve managed for a long period of time and, therefore, that is in the shape that I want it to be in, so no plans to shift it or change it materially, other than if the investment rationale changes, which is obviously the case for all portfolios that I manage. But in terms of the process and the approach, nothing will change.
Q: And that approach will also apply to the Edinburgh Investment Trust?
Mark Barnett: Yes, the Edinburgh Investment Trust is going to fit into my stable of portfolios as of yesterday, so I’ve started managing it already. And the approach that I’ve used for all my funds will be reflected in the Edinburgh Investment Trust as well. And over time, I will be making changes to reflect some of the differences that I want to emphasise versus what’s been in there historically. And I’m not talking about a complete revolution here. This is an evolutionary idea. People must understand that the kinds of portfolios that I’ve been managing are not drastically different from the sort of funds that Neil’s been managing, and Edinburgh’s been managed by Neil for the last few years. And therefore, as I’m taking on this portfolio, I’m looking at it thinking, ‘Well, there are lots of stocks there that I own and that I want to continue to own’, maybe not in the same proportions, but we’re not looking at a wholesale take-out of this entire list of companies and putting in a brand new list. That’s just not the case.
Q: What are your views on the outlook for the UK economy?
Mark Barnett: I think that the UK economy is doing okay. It’s certainly a lot better than we thought it was going to be 12 months ago. We mustn’t forget that it wasn’t even 12 months ago that the papers were still worrying about a triple-dip recession, and here we are, eight or nine months later, talking about the best growth rate in the G20, or certainly in the G7. So, good and better than we’d hoped for, but let’s not get carried away. The growth rate that we saw reported yesterday, I think, is about as good as it’s going to get, in my view, and that will start to moderate through the course of this year. And I think a more realistic outcome for this year would be a growth rate of around 1.5 or maybe a bit higher, but certainly not to the extent of the 2.8% registered yesterday.
And the reason why I would maintain a certain degree of caution is twofold – two or threefold – firstly, banks are not really lending. Bank lending is crucial in an economy like ours in order to kick-start self-sustaining recovery. Credit creation in the economy is, in aggregate, not growing. There might be more going into the mortgage market than there has been in the past few years but the SME market is still under pressure. So, in aggregate terms, net lending is not growing and that’s a problem for an economy like ours, which is built on credit, frankly. And we’re not alone: many countries around the world also feel that pressure.
Secondly, business investment hasn’t picked up. And I know the politicians are saying, ‘Well, it’s about to happen’, but we are five years post the crisis now and there’s been a huge amount of stimulus thrown at the economy and one would imagine the figures would be better than they are. So, I think that’s, to me, a sign that businesses are not yet exhibiting huge amounts of confidence in the sustainability of what they’re seeing.
And finally, the wage-growth issue: it could be possible that real wages will grow this year, because inflation is coming under pressure, but there certainly isn’t the pressure from businesses to put wages up by substantially more than they have done historically. And ultimately, in order to feed a self-sustaining recovery, we need to see wages going up in order to put more money into people’s pockets. And up until now, what we’ve struggled with is, actually, wages have been going up a lot less than inflation; therefore, real take-home pay has been falling. And if it crosses the zero line this year, that will be a positive, but this certainly isn’t a kind of ‘pin your ears back for a super-duper recovery’-type situation.
Q: Some commentators have expressed concern about what they see as a risk from another housing-market bubble. Is that something that keeps you awake?
Mark Barnett: The housing market – I don’t see it. There are certainly bubble conditions in certain parts of the economy, particularly London and the southeast, where there are some very, very heated property markets but, outside that, I would say it’s patchy. There has been an improvement but I don’t think we could call this a full-fledged bubble yet. What I would say in answer to that, though, is that we have a new committee that sits alongside the Monetary Policy Committee, called the Financial Policy Committee, and one of the key areas that they will be focusing on is the strength of the housing market and how the government, which is putting a lot of work behind the housing market with the Help to Buy scheme, and the banks potentially are fuelling a housing market which might be getting overheated.
So, they are very much alive to the issue and I think they’ve certainly made comments that they are prepared to bring in macro-prudential policy to adjust some of the policies of the banks; in other words, multipliers that are given on salary or actually bringing in a cap on loan-to-values, so that they will require people to put in more equity into the properties. Because one of the things that they would be worried about is very large-scale mortgage-equity withdrawal and the reappearance of very high loan-to-value mortgages – the 90%-plus mortgages – which were such a big feature of the housing market in the mid-noughties, which partly led to the crisis. So, we’re not seeing it yet although there are one or two worrying signs around, but I think the Bank of England are really going to be hot on this and will be trying to put the brakes on before the thing gets carried away.
Q: When do you see interest rates going up in the UK?
Mark Barnett: Well, Mark Carney’s change of heart last week to suggest that, actually, the unemployment indicator of 7% wasn’t going to be the key trigger leads me to believe that he’s in no hurry to put rate up. I think he sees some of the issues surrounding the economy, which I’ve just mentioned with regard to particularly the uneven nature of the recovery, I think he sees risks around that and, therefore, he is tempted to leave rates on hold for the foreseeable future. I don’t think it will happen this year. We may start to see it early next year but, even then, it’s going to be gradual. It might not even be 25 basis points every meeting; they might start doing it in increments of 10, which has been suggested by a few people as being the way to gradually get the market’s head around rising interest rates without pushing up money-market rates too fast, because the risk is that the markets will push the gilt yields too fast, the curve will show a much steeper slope to it, and that will be a problem for households and for the government because of the outstanding debt that we have.
Q: Do you see the UK market as fairly valued presently? Is it still an attractive market?’
Mark Barnett: Well, a tough question because we’ve had a very, very strong run in the UK and other major equity markets – certainly developed-world equity markets – over the last few years, and the bulk of the price move has come as a result of multiple expansion; in other words, the re-rating in price-earnings multiples of the market. Very little has come as a result of earnings growth. In fact, one of the key features of the market move over the last few years has been the lack of earnings and the lack of profit growth. So, my hunch is that we are then looking on the expensive side of fair value.
Certainly, the relative attractiveness of equities over bonds, which has been an argument that I and others have used for a long while now, where you saw a big differential in the dividend yield that you would receive on the equity market versus the 10-year gilt yield, that differential is much, much narrower now than it has been over the past few years. In fact, there’s not even 0.5% differential between the two now, so the relative-attractiveness argument, albeit it still just about valid, is a lot less strong than it was 12 months ago and, therefore, I would argue that, if you are buying equities, I do see pockets of value.
I think you need to be much more vigilant on where you look for value in the market, but if you are buying equities, you’ve got to be sure that you have strong absolute valuation and support for the equity you’re buying, and not just say, ‘Well, it looks relatively cheap compared to cash or compared to bonds or property; therefore, equities are the only place to put my money.’ As I said, that argument’s a lot less valid than it was and, particularly, we need to be careful on where we’re putting our money, because the one thing I do know about this market is valuations have risen to a level where, if there aren’t earnings and profit performance in terms of growth coming through, there will be price vulnerability and you will see the scope to lose money in this market if you don’t have the earnings growth to back up what you’re paying for the stock.
Q: The small and medium caps outperformed large caps during 2013. Do you expect that trend to continue?’
Mark Barnett: Big picture, probably not. There has been, as I said, a significant multiple and valuation increase, particularly seen in the mid- and small-cap area, where you’ve had very strong growth in prices over the last 12 to 24 months, and I can’t suggest to you that I think that that is going to continue expanding. Clearly, where there is earnings growth to back it up, then that will continue but, as an overall view, no, I don’t think you’re going to continue to see the mid caps forging ahead relative to the FTSE 100.
The big call on the FTSE 100 is, unfortunately, as it always is, a call on the largest companies, because the mega-caps form such a large proportion of that index and, therefore, if you are going to see a narrowing of the gap, you have to partially take a view on what you think those very, very large companies are going to do. It may just be the case, as I would suggest as an overview, that, actually, what we can expect from the equity market this year is a lot lower return overall, and we certainly shouldn’t be gauging our expectations off what we’ve seen over the last two years, which is some very strong growth in returns; actually, this year might be a more modest year for returns.
Q: Ten-year gilt yields are tempting some buyers back into the market. If gilt yields move above the FTSE All-Share yield, will we see a negative impact upon UK Equity Income stocks?’
Mark Barnett: There is no doubt that the initial reaction for people who are buying equities that have bond-like characteristics, namely the steady-income-generating, dividend-paying companies – utilities particularly noteworthy in this respect – but there is certainly a reaction to owning some of those stocks when people perceive that the risk-free rate – i.e. the gilt yield – is offering a higher yield; and therefore, the performance of those equities suffer in the short term, as people say, ‘Well, I don’t need to own those types of equities when I can own a gilt which offers me a better return at lower risk’, in theory.
Unfortunately, that argument doesn’t work in the long term. Why? Because, actually, what these equities can provide you, if you’re in the right ones, is long-term growth dividends, which you will never get out of the gilt yield. And if you’re in the right businesses, you’ll get not only the certainty of that yield but the long-term growth in that yield and, therefore, ultimately, I don’t think it is necessarily the right thing to be switching money out of those sorts of companies just for the sake of understanding where the bond yield has moved to.
Q: What is your view on pharmaceuticals and tobacco stocks?
Mark Barnett: I own shares in a number of pharmaceutical companies, and tobacco, both UK and non-UK listed. In fact, in the pharmaceuticals sector, my biggest holdings are non-UK-listed pharmaceutical companies, where I can own and have been able to own up to 20% of my funds outside the UK. Actually, I think that, in many respects, companies like Roche and Novartis are better businesses than their UK counterparts, albeit they might be more highly rated, so that’s something that I have to take into account. But as an overview, I do think the pharmaceuticals sector remains interesting.
The big picture is a very positive one: ageing populations in the west and increasing wealth in the emerging markets means that the demand for their products is still very strong; an FDA which now appears to be a lot less restrictive in terms of awarding licences to new products coming through. There was a period 10 to 15 years ago where it appeared that the FDA was much more restrictive; I think that’s become less so. And also the huge technology changes that are going on in the industry, driven primarily off the mapping of the human genome, which occurred in the late 90s. It’s taken 10 to 15 years for the industry to evolve that and to create products which are driven off biological research rather than chemical research. Biological research, to my mind, is where the entire industry is now moving and there is a lot of evidence that personalised medicine is going to be a big feature going forward, and that should play into the hands of the drug companies in terms of success from pipelines.
What we’re finding, of course, is that the stock market, having de-rated them substantially, has started to re-rate them, but is still only applying a pretty low probability of success to a lot of the pipeline products. So, I would say that this is a combination which, to my mind, still looks attractive, and I think the trajectory of pipeline success for these businesses is going to be a lot more positive over the next few years and, therefore, that would lead me to want to hold some big weightings in that.
Tobacco: still very happy with the tobacco sector, notwithstanding the fact that there’s quite a lot of noise and mud being slung at the sector.
There has been certainly, as we speak, and certainly in the last six to 12 months, partly as a result of the earlier point about the bond-proxy-type argument: these are seen as the safest of the safe havens. And also, there’s a lot of nervousness about the e-cigarette market and how that’s going to change the picture for regular cigarette consumption, as well as plain packaging. The fact of the matter is there are trends that have been working through the tobacco industry for a long while now. There may be some markets where volume declines are faster than we’ve seen historically, but I don’t think necessarily the overall picture, to my mind, is necessarily more negative than we had this time last year.
The valuations of the companies are certainly a lot lower than they were last year; these businesses have been de-rated and, to a certain extent, they are vulnerable to emerging market currency weakness as well – particularly BAT, a very large business in the emerging world – but have the characteristics that I identified historically and I wanted to own historically: very strong cash generation, managements very aligned with shareholders, very substantial cash returns to shareholders. Have those characteristics changed? No, they haven’t, and I think, at the moment, these companies offer quite substantial value in the market, and that would be an area that I have been increasing and would be increasing and would be interested to increase in the funds at the moment.
Q: What are your thoughts on banks and the rest of the financial sector?’
Mark Barnett: Well, financials, to me, have historically – and certainly in the recent past – been a part of my portfolio. I have held big positions in quite a lot of mid-cap financials, not necessarily the large-cap ones, although I have held Legal & General. That’s my one large-cap financial holding. What I haven’t done is buy banks. To me, the bank sector remains challenged. Notwithstanding everything that they tell us about how the problems are behind us, only this week we had another announcement from the Royal Bank about more provisions for what I would call sins of the past, and they’re still working through quite a lot of issues with regard to the restructuring of that bank.
The big picture for banks, to me, is no loan growth, so top lines not really growing; they’re working hard on cost and, to a certain extent, they’ve improved their earnings performance because the impairment charges have come down significantly in the last 12 months. The backdrop for banking, though, is, if you’re not growing your top line, in my mind it’s going to be difficult to continue to grow earnings; secondly, I worry about impairment charges picking up; and thirdly – and probably most importantly – the regulatory side continues to concern me.
Why? Because the regulators are being, to my mind, charged by the government to ensure that these companies do not have to have recourse to public funds again, and that means that regulation in terms of capital requirements and the buffers that they need to put into the business, into the balance sheet, are probably going to go up. This isn’t just the UK regulator: if you look at what’s happening in the US or in Hong Kong or in Switzerland; we’re about to see, later this year, the bank-stress tests in the eurozone. The regulators, to my mind, are pointing in the same direction, which is tighter regulation over time, to the point where they feel that these banks are sufficiently capitalised.
We’re not there yet. The direction of travel, to my mind, is clear, and how long we take to get there is still unknown, but what I can say is I don’t think we’re there yet, so I would suggest that, over time, there is still regulatory pressure in the background on these organisations, and I don’t think that’s necessarily a great thing for the equity-holders.
Q: You mentioned your interest in Legal & General. Does that imply that there are other areas of the financial sector in which you continue to be interested?
Mark Barnett: I do, and just expanding the point there, much of my financial interest has been in the non-life-insurance sector, so the mid-cap stocks – Hiscox, Beazley, Lancashire; those types of businesses – which are offering quite different risk profiles. Obviously, they’re wholesale insurance businesses and reinsurance businesses. They are exposed to different, uncorrelated risks – the catastrophe-insurance markets, which are completely uncorrelated to the wider economy – and they’re extremely well-managed businesses and offer quite attractive return on equity and profile of returns to shareholders, allied to which I’ve also had big positions in Legal & General, Provident Financial, the LSE, all of which are doing somewhat different things and are exposed to different parts of the financial-services industry. And also property companies, which is an area where I have had some holdings in some of the medium and smaller property companies historically. And so, that’s gone to putting together quite a big financial weighting in my portfolio, albeit in areas which are in some of the smaller or medium-sized companies.
Q: What is your attitude towards investing in unlisted stocks?’
Mark Barnett: I have taken an interest in investing in unlisted stocks. A small number of unlisted companies are in my portfolios – much less than you would find in the Income or the High Income Fund. And I do believe that there is a case for long-term investors to have a proportion of assets in unquoted companies. Many of the companies that we in the team have invested in, and the few that are invested in my portfolio, have come from relationships which we’ve developed with the university commercialisation businesses. So, there are a few quoted in the UK market – Imperial Innovations, IP Group, Fusion – that are basically taking ideas out of university laboratories and putting them through a screen for commercial prospects and then taking very, very few – a small number – of them making businesses of them. They have offered us the opportunity to co-invest with them as they’re investing in these businesses, and I think that is an area of significant interest for a long-term investor and it’s certainly well off the beaten track for most investors.
It is the case, as we all know, that universities in the UK historically have generated lots of good ideas; what we have been less good at is getting them into commercial reality. And these commercialisation companies are the means to be able to do that. And I think, to my mind, it’s an area of significant interest and probably significant undervaluation in the UK economy, because so few people are looking at doing this. So, if I can offer financial backing in a small way in my funds to these sorts of companies, then I think that is an appropriate thing to do.
And obviously, when I take on the new funds, I will be inheriting a substantial list of those businesses, which I’m using this time, as I said earlier, to get myself up to speed with and, actually, where I’m finding there are some very interesting and exciting prospects. I fully contend that a number of those businesses won’t make it to the end place but, by the same token, if I manage to get three or four out of 10, I think that’s a pretty good strike rate. If I get three or four out of 10 to work, then that will take care of the ones that don’t, so the returns could be quite substantial in the ones that actually do turn out well
Q: What are the most important qualities of a successful fund manager?
Mark Barnett: I think you have to be patient, you have to take a long-term view, and you have to imagine yourself as if you were buying not just a share in the business but the whole business. In other words, what is it about this company or investment that is attractive? And you have to see the dialogue that you have with management and the way that you understand it as if it was a private company – as if it wasn’t listed. So, you have try to understand what is it about the value of the business that attracts you and keep focused on that, and not get bumped around by what the market’s telling you on a day-to-day or hour-to-hour view, because there’s a lot of noise in the market and, actually, what you really need to do is stick to your knitting, focus in on the fundamental strengths of the businesses that you own or the ones that you might own, and stick to that as a point of reference as to whether or not this is going to be a good investment. And that’s the biggest challenge for a fund manager who’s trying to cut out the noise: just stick to your knitting because, actually, that’s what’s going to deliver the best returns. But those would be the qualities that I would highlight above all else.