David Clark, UK Analyst, explores the “cheapness” of the UK market…

Buy Now While Stocks Last

 

With every passing day the likelihood of a hard Brexit seems to grow.

The Prime Minister is in full pursuit, like Captain Ahab before him, of his own personal white whale and be damned as to the consequences. His “do or die” rhetoric certainly appeals to sections of the media and the political classes, and it is without doubt a refreshing change from the torture of his predecessor’s premiership. However, it has done no favours for investor sentiment which has improved not a jot since his ascension.

The consequences of Mr. Johnson’s position are debated furiously and have filled millions of column inches in newspapers, periodicals, blogs and websites. There seems to be little that they can all agree on.

Actually, there is one thing. As a result of a hard Brexit sterling will fall further. This small but rather important fact does not seem to be in dispute.

The value of the currency has been highly volatile since the 2016 referendum, having traded down to $1.205 in early 2017 then bounced back to $1.434 a year later. Prior to the referendum, the last time sterling was trading below $1.25 was nearly 35 years ago, and since Boris became PM the already pressurised pound has faced further headwinds.

From an international investor’s point of view this is all very fortuitous. It is clear that many LSE quoted companies are trading at significant discounts to historic norms and their international peers, and sterling weakness exacerbates that. This naturally makes them more attractive to overseas investors, and that is all fine and dandy and part of the natural way of things.

However, this has coincided with a time when there is a great deal of money being set aside by private equity firms, corporates and other investors to make outright bids for a chunk of UK (and other) companies. UK merger and acquisition activity has significantly accelerated over the last few months. Only last Monday a veteran stalwart of the market, Greene King, was bought by an international investor (CK Asset Holdings) at a 51% premium to the prevailing price in the market because it made sense to the acquirer.

Greene King is far from alone. We have seen other private equity bids of late with Merlin grabbing the headlines not so long ago, as well as the likes of Inmarsat, Tarsus, RPC and Millennium & Copthorne all in the process of being taken private. The PE industry is sitting on over $2 trillion that it needs to invest. In addition, we know that there is even more money due to come in from investors with much of this cash going to mid-market buyout funds. Prequin Investor Interviews suggested that 54% of investors thought that the best opportunities were to be had in small to mid-market buyout funds.

Obviously, the UK market is not the only one in the sights of the buy-out funds, but they would have to be a special kind of stupid to ignore the opportunities that are being thrown up on these shores, especially while sterling remains supressed. And these people are not stupid.

The last time there was a private equity acquisition boom was in the years 2006 and 2007 when over $800bn of listed companies globally were bought up in only those two years. This time the PE industry has more than twice the firepower it had then. Over the same period this buyout trend saw the ‘stock’ of equity in the UK market fall 8% over those two years according to Datastream.

As a domestic investor in UK stocks this trend is of great interest. Clearly, the extra sweetener provided by the currency aspect does not apply, but there is no harm in speculating as to which other companies may come under scrutiny from the men with deep pockets.

No one should ever buy a company just because they think that it is going to be taken over – that way lies madness (and bankruptcy), but it does no harm to be cognisant of the possibilities. Which brings us to the tricky bit – trying to figure out what sort of business would be attractive to potential acquirers.

There are umpteen different types of buy-out funds who all employ different criteria in order to assess potential investment opportunities. Screening for every eventuality is not a particularly good use of one’s time (unless you have a great deal of it), so sweeping generalisations will inevitably be called for and it should be taken as read that any stock which the rational investor considers for purchase already ticks the appropriate boxes according to one’s own favoured criteria.

That the opportunities are out there is beyond question and it is inconceivable that anyone will identify every takeover target. However, catching just one or two can make a world of difference to a portfolio’s investment returns. It is worth the effort.

 

David Clark

UK Investment Analyst, Saracen Fund Managers

 

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UK Analyst David Clark tells us about a day in his life…

How do you start your working day?

Reluctantly, usually. I’ve never been much of a morning person yet, rather foolishly, every job I’ve ever had required me to get out of bed at stupid o’clock. Actually, I don’t mind so much just as long as no-one tries to speak to me for the first hour or so.

Living in Glasgow and working in Edinburgh means up at 5:45am and out the door by 6:10. Thanks to the modern miracle that is ScotRail (!) I am at my desk by about 7:40 having scanned my emails and the pertinent news of the day, as well as usually managing to cram in a few chapters of whatever novel I’m working my way through at the time. (The last book in a series about the Roman Emperor Vespasian, since you ask – very exciting!)

From then on, every day takes its own turn.

What does a typical day at Saracen look like for you?

I may be meeting with a company that we are thinking of investing in or have a current interest in or I may be meeting clients. There may be issues to discuss with my colleagues, observations to be made, or portfolios to be reviewed. At any given time, I generally have a list of companies that I am going to either update our proprietary financial model or begin an entirely new model. This is a thorough, deep dive on the company and we prepare forecasts looking out 5 years in an effort to identify underlying valuation anomalies. We are well aware that these forecasts will not be pinpoint accurate, but they are amazingly instructive to construct. In addition, we always factor in our ‘worst case’ scenario into our assessment which helps provide a suitable margin for error.

These models are variously time consuming, engaging, frustrating and illuminating. Faffing about with amortisation charges is no way for a grown man to spend his time. Still, it has to be done – and it is always worth it.

Tell us about your career so far.

I completed a degree in Accountancy at Glasgow University in 1986 and for a brief (6 months), unhappy time was actually an accountant. I still shudder when I think of it. However, in 1987 I joined a company called Scottish Mutual Assurance Society in Glasgow in their investment department as an analyst. That was when my real education began. It was hectic, chaotic and intense. These guys worked hard and played hard and I pretty much loved every minute of it and learned a great deal. In 1994 I moved onto what was then called Britannia Asset Management and eventually became Ignis Asset Management having gone through a variety of name changes. I stayed there for 20 years managing all kinds of funds, but the last 10 years were spent managing all of the UK Smaller Company monies. Excellent experience and very good fun.

When Ignis was taken over by Standard Life Investments I worked as a Non-Executive Director for a couple of small companies for a couple of years until the world of fund management beckoned me again. I missed it and was very fortunate to find the nice people at Saracen who were looking for someone to help out. So far, so good …

What was the biggest learning curve in your career?

I think I’m still on it. It’s always a joy and privilege talking to people who are smarter than me and the older I get the more I realise I don’t know. As the old saying goes, “I’m not young enough to know everything.” Investment management is as much art as it is science and a careful blend of the two, in my experience, tends to produce the best results.

What advice would you give someone starting out as a fund manager today?

Listen. Learn humility and remember your mistakes – you’ll make plenty but hopefully not the same ones twice.

What is the company culture at Saracen Fund Managers?

Very relaxed. We are a small team, all of whom have at least 20 years’ experience of investment analysis and fund management and have therefore been round the block a bit. There are no egos (thank God!) and there is a very open culture of constructive challenge to one’s views. Not only is it quite fun defending one’s position (and querying other people’s positions) but it really does test the resolve of that opinion and exposing it to intellectual scrutiny is always a helpful exercise. Of course, it’s always nice having one’s mistakes pointed out too!

Any favourite haunts for lunch?           

Not really – I don’t know Edinburgh well enough yet, so I’m becoming more of an expert on the various sandwich shops locally.

How do you relax in the evening?

Depends on the evening. I’m as much a fan of box sets as the next man and am currently working my way through ‘Good Omens’ on Amazon. I read the book years ago and loved its silliness. The series is every bit as barking mad. Good fun.

I’m also occasionally to be found trawling at rock concerts in Glasgow. As with many people of my vintage my tastes are massively influenced by the 1970s and 80s. As such I can often be found marvelling at the digital dexterity of Michael Schenker or the wonderful guitar harmonies of Lynyrd Skynyrd. Just so as you don’t think I am a complete dinosaur – I went to see The Sheepdogs recently. Bet you haven’t heard of them.

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Bettina Edmondston, Global Analyst, examines the ‘universally loathed’ tobacco sector…

Tobacco Earnings Going Up In Smoke?

 

During recent meetings with our clients it became clear that the tobacco sector is universally loathed.  This contrasts with the wider staples sector, which seems to be over-owned and overvalued to us.

As the chart below highlights, since the start of 2018 global tobacco has underperformed the broader staples sector by 35% and the overall stock market by 38%.

Part of this is due to the derating of tobacco shares and the rerating of the remainder of the staples sector.  The PE differential between the 2 has increased by over 8 points over the last 18 months:

At the same time the dividend yields on tobacco have grown to almost 2.5x those of the overall staples sector:

There are various widely known reasons for tobacco’s underperformance, such as the acceleration of combustible cigarette volume declines (see chart below), concerns about over aggressive pricing, potential new regulation from the FDA and ESG concerns.

We own two companies in the global tobacco sector namely; Imperial Brands (IMB), the deep value play on developed markets and Philip Morris International (PMI), the growth play on emerging markets and the new “Heat not Burn” technology (IQOS).

In our view share prices do not reflect the positive EPS growth and double-digit total shareholder return we expect these companies to deliver over the next five years and beyond.

In the case of IMB we see the more streamlined cigarette portfolio as very well positioned in its top 5 markets (US, Germany, UK, Australia, Spain).  IMB’s brands are towards the value end of the spectrum and should benefit from consumer downtrading, which has started to happen in the US.  We, therefore, do not see profits from combustible cigarettes going up in smoke!

IMB was a first mover and is now one of the leaders in vaping/e-cigarettes.  We don’t know which Next Generation Product (NGP) will win, but we assume it will be a mixture of options.  Imperial’s myblu has the highest market share in retail in Germany, Japan, France and Italy.  It is also strong in the US and the UK.  There is potential for margin increase as these products become a bigger part of the portfolio.

Some market participants seem to be concerned about IMB’s leverage.  Whilst net debt/EBITDA at 2.6X is towards the top end of our tolerance levels, it is still very manageable for a company that generates significant amounts of free cash flow.  We forecast £2.5-3bn of FCF p.a. on a market cap of £19bn and net debt/EBITDA to fall to less than 2X over our 5-year forecast period.  However, Imperial has a £2bn disposal programme, including its luxury Cigars business, which will be complete by the end of March 2020.  Part of these proceeds will be used to reduce leverage even further – which we estimate will bring it closer to 1.5x in year 5.

At the same time management is adamant – and we would agree – that the threat to the dividend is “non-existent”.  We have increased confidence in the sustainability of the dividend post the recent announcement of a new capital allocation policy whereby from 2020 the dividend will grow in line with earnings.  We had engaged with Management about the futileness of the old 10% annual increase in dividend and queried why they were not engaging in a share buyback program given the rating on the shares.  We were therefore delighted to see a share buyback announced alongside the change in dividend policy.  Furthermore, there is scope for even bigger programmes in outer years.

As ever, valuation is the key for us.  The 7x PER and 10.5% yield (source Bloomberg; 09/07/19) implies that the business model is broken, and the company is in financial distress.  We disagree!  On the conservative view that the share holds its current 7X PER ratio, our assumption of underlying EPS growth of 3-4%, accretion from the share buyback and the yield to give us a total annual shareholder return in excess of 15%!  Clearly if the company can deliver on its targets the shares will also re-rate from the current low levels!

We think if the market doesn’t recognise the value inherent in Imperial someone else will; either an activist investor, trade buyer or private equity.

The investment case for PMI is different.  PMI has no direct exposure to the US and is a play on Emerging Markets.  Its biggest markets include Turkey, Russia, the Philippines and Indonesia.

We have followed PMI for a while and listened to the company’s growth strategy  for its “Heat Not Burn” product IQOS with interest.  While we always liked the strategy, we were never comfortable with the lofty valuation of the shares.  However, after two profit warnings in 2018, the shares de-rated massively and we initiated a holding in July last year.

We believe that the guidance is now much more conservative and expect upgrades to come through over the next year or two, driven by continued growth in IQOS in Europe and South East Asia, combined with slight margin expansion and the potential of a share buyback porgramme in two years’ time.

PMI’s has first mover advantage (by some distance) in “Heat Not Burn”, has strong market shares and continues to lead innovation in this space.  We see it as a long-term winner in the non-combustible nicotine space.  We expect PMI to be able to grow its earnings by approximately 5% per annum which combined with a 6% yield should give us a double digit total return.

In conclusion, despite the uncertain backdrop, valuations are now reflecting a huge amount of pessimism about future earnings and cash generation.  Given that dividends are secure, we think the sector is massively over-sold and we have recently bought more of IMB and PMI.

Bettina Edmondston

Global Analyst, Saracen Fund Managers

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Graham Campbell discusses the curious enthusiasm for expensive shares…

Graham

Peak Quality?

A colleague attended two meetings on the same day last week in Edinburgh.  The first, with the IR of Britvic, the soft drinks consumer company, was attended by around 17 interested investors; the second with the FD of Barclays, was attended by two!

This enthusiasm for all things consumer/staples was backed up by feedback from a recent investor trip to London.  There is an appreciation that businesses classified as ‘Quality’ are expensive, relative to their history and compared to other investment styles, but we came across few sellers of shares in this classification.  It reminded me when valuations became detached from expectations during the commodities and tech booms: there are few sellers at any price.  When this mood takes shape it frequently suggests that we are entering dangerous territory.

I am wary of applying titles like Quality, Growth, Value and Defensive to describe a business, as these characteristics and are present to a greater or lesser extent in all investments.  Also, some factors vary in relative importance over time as the industry or company changes (e.g. Vodafone was regarded as a growth stock in 2000 when it was the largest UK quoted company, is now regarded as a value stock after declining almost 75% and recently cutting the dividend).

For the sake of discussion, I will consider Quality to be a measure of sustainable cashflow, that delivers a high rate of return above the cost of capital.  This is an attractive characteristic as returns are more predictable, but also because by generating a real return, the business creates value.  However, this is only part of the story, as some businesses generate a positive return on capital employed (ROCE), but are unable to deploy surplus capital to earn the same return.

Take WD 40!  It’s a fine business: every garage and shed has a can in case a nut is too tight or to loosen up some equipment.  It earns a consistently high return on capital.  However, as we are all unlikely to spend more of our lives loosening tight metal objects, a can lasts for years and the growth prospects are limited.  In the 5 years to August 2018, revenue growth averaged a modest 1.6%.  It is fair to add that management was able to boost earnings by more than this by using free cash to buy-back shares. Nevertheless, the shares are now valued on a prospective Price Earnings Ratio (PER) of over 32X and yield 1%.

It is not just WD 40 that appears to us to be expensive for expected growth: investors appear willing to pay higher valuations for businesses with quality attributes.  The chart on the left below shows the strong outperformance of Quality.  However, the chart on the right indicates that this has not been matched by an improvement in forecast earnings.

The example of WD 40 aims to illustrate that while quality is an important factor in assessing a business, investors must also consider growth and of course price.  The price you pay is the basis of all future returns and it cannot be ignored when buying shares, or when assessing any other investment opportunity.  This boils down to: there has to be a level when an objective investor considers a share as cheap and worth buying and another level when the price is too high and no more should be bought or selling should be considered.  Is Quality cheap at any price?

This does not feel like the market environment we are currently enduring.  There is little price support in some areas and only buyers in others.  It is not my intention to attempt to convince objective investors in this blog that an alternative strategy, such as Value is cheap, but to highlight that some Quality businesses appear to us as expensive for the growth that they are forecast to deliver.  History has shown that owning highly rated shares that do not deliver is a painful experience, as the examples of Anheuser Busch, Reckitt Benckiser and Kraft Heinz demonstrate. The chart below graphs the relationship between Like for Like Sales Growth and the PER. With 75% of the movements correlated, the chart suggests that investors are willing to pay a PER of 20X for 4% growth and around 28X for 5% growth.

Many of shares considered as Quality appear to us to be in a space that is expensive, overbought and crowded.  Most investors we meet have some sympathy with the valuation argument but search for a visible catalyst to make this happen.  Experience has shown that most catalysts are really only clear in hindsight.

There remains a close relationship between Quality and bond yields.  These Quality shares appear still to be the bond proxies!  If we follow the Japanese example and bonds yields fall further and stay low, then maybe these shares will continue to out-perform and for some time.  However, we argue that with versions of QE applied across many countries, we have a large price insensitive buyer and bonds have therefore lost much of their predictive power to be a barometer of expected inflation.

In contrast, we expect to find more attractive investment opportunities in a less crowded environment.  The TB Global Income & Growth portfolio has not been as Value biased or cyclically orientated, since launch almost 8 years ago.  As can been seen below, this focussed portfolio is differentiated from our Peer Group and any relevant Index.

There is a risk that we enter a global recession in which case more cyclical businesses will suffer: we still view this as unlikely.  Growth is more likely to persist at low levels.  We value Quality as an attribute when we consider a business for investment, but we also consider the relationship between the prospects for growth and the forecast valuation of the shares.  We also have strong views about balance sheet strength.  Owning expensive shares in the hope that they keep going up is a dangerous endeavour.

Graham H Campbell

Joint Manager of TB Saracen Global Income & Growth

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Bettina Edmondston, Global Analyst, fills us in on her typical day…

How do you start your working day?

My alarm goes off at the leisurely time of 6:40 and I listen to the news for a few minutes.  Currently, this gets my blood pressure going enough to make it out of bed before 7am. After a quick shower and 10min stroll down the hill, I’m on the bus at 7:30 and in the office by 8am.  At this point I will have checked all the emails and news that have come in over night or early in the morning. During result season, this could be quite a lot to take in before I hit the desk.

The first hour in the office is usually spent digesting all the newsflow, discussing with the team what implications there might be for our portfolio and if we have to act on any of this.

What does a typical day at Saracen Fund Managers look like for you?

No two days are the same at Saracen Fund Managers or indeed in this job. That’s why I still love it after almost 20 years in the industry. It’s so varied and interesting. I could get lost in an Excel spreadsheet for a couple of hours working out the growth potential for a Chinese sporting goods company.  This could be followed by meeting the management of a German chemical company and discussions about big global themes (ban of plastic, lighter materials for electric cars, innovation in food ingredients) and their business strategy over the next 3-5 years.

In general, 80% of my time is spent analysing business models and creating or updating our inhouse proprietary templates on a specific company. Here at Saracen, we have the freedom to choose what we want to look at. We are not constrained by a benchmark and we have no geographical requirements to fulfil. Neither are we burdened with bureaucracy or unnecessary meetings. We are a small team and what needs to be discussed is mostly done in an informal way. That leaves time for the interesting and highly productive part of this job, namely analysing companies.

I enjoy meeting clients to discuss our fund and outlook on the market. I find this very rewarding as we get to find out what our clients worry about and how they are positioned. The best part is the discussion and when we get challenged on our holdings or views on the world.

Tell us about your career so far.

I have had a very diverse career within the investment industry covering various positions and working in different countries. Starting off as an economic researcher at Brewin Dolphin in Edinburgh, I moved on to Scottish Widows Investment Partnership where I first worked with my colleagues Graham Campbell and David Keir. That’s the thing about Edinburgh, it is such a small place that you always come across the same people, either in different work places, at company meetings or at functions.

Over the next few years, I worked as an analyst for The Alliance Trust and Aegon (now Kames) covering the European and US markets and sectors ranging from Staples and Healthcare to Chemicals and Banking. In 2011, I moved to Zurich where I worked as a sell side analyst for Kepler Capital Markets. Unfortunately, neither my husband nor I enjoyed our time in Switzerland. We decided to give Germany a go where I had a fund manager position working on a global Healthcare portfolio in Dusseldorf. But in the end, we returned to Scotland – back to where it all began. In 2015, I joined my previous colleagues here at Saracen and I haven’t looked back since.

What was the biggest learning curve in your career?

Don’t listen to the noise but trust your instincts. Unfortunately, there are so many commentators who all try to convince you their opinion is the right one. If working on the sell side has taught me one thing, it is to take these reams of research with a massive pinch of salt. These days we don’t spend much time reading research and we don’t meet analysts. We invest with a comparatively long-time horizon and we are not concerned about the next quarter. In our analysis we find more helpful information in annual accounts or management discussions rather than in re-hashed arguments.

We are not always right in our job. The important thing is not to lose confidence in your own analysis and gut instinct. Over time I have learned that sticking to my guns rather than following the herd tends to work out in the long run, even though sometimes it might be painful in the short term.

What advice would you give someone starting out as a fund manager today?

This might sound counterintuitive to the previous paragraph but “listen and learn”. When you first come out of university, you think you’ve learned it all out of text books and are ready to go. This job is about life long learning and there’s never an end to it. It’s not just learning about different business models, portfolio strategy or investment philosophy. It’s learning from your peers, people who have been through a couple of economic cycles, company managements, etc.

But most importantly it’s learning from your own mistakes, because you will make them. Some of them might be painful but the lesson is that you won’t repeat them. That’s why experience still counts so much in this industry. If you don’t have an enquiring mind and a willingness to be open to criticism, this is not the job for you.

What is the company culture at Saracen Fund Managers?

My colleagues and I have all worked for large investment houses where your main job gets interrupted by bureaucracy and endless meetings, which half the time are unproductive. We are very streamlined here at Saracen. Most back office functions are outsourced. There are no strategy meetings and no “time wasting” meetings. We sit in a semicircle and communication is ad hoc and straight to the point.

Another aspect is that we are all on the same level. Each person’s opinion counts the same. There is virtually no hierarchy at Saracen. We’ve all worked with people who think their views and beliefs are superior to others. We do challenge each other but it is in done in a constructive way as we all want the best performance for our funds and company rather than proving a point.

Any favourite haunts for lunch?

As I’m recovering from years of back pain, I try to go swimming as much as I can at lunch time. In reality, that probably only happens twice a week. Eventually, I want to be fit enough to go back to lunch time running.

If we go out as a team, we like to go to a small Italian place called Quattro Zero, just around the corner from our office. For a while it was called our canteen! It’s cheap and cheerful and great for an informal lunch. If you want to make me really happy, take me to Kyloe for a nice steak. I can’t say no to that.

How do you relax in the evening after a long day?

On the way home I obviously have to climb back up the hill that I had a leisurely walk down in the morning. We live on the side of Arthur’s Seat and if you know Edinburgh, you are aware that it can be quite steep in places. If it’s a nice day, my husband might drag me out to walk up the rest of the hill, which is another ½ hour. But you get rewarded with fantastic views over the city, the Lothians, the Firth of Forth and Fife. I always find it amazing to live in the middle of a cosmopolitan city and still have access to a big park and a hill to climb basically at the back of our garden.

On the weekends we try to get out for day trips, either by train or on the motorbikes or for another longer hill walk (depending on the famous Scottish weather). There are so many places you can reach within 1-2hrs from Edinburgh, like Glasgow, Newcastle, the Perthshire hills, Loch Lomond, Northumberland…. The world is your oyster. I never get bored.

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Bettina Edmondston, Global Analyst at Saracen Fund Managers, examines the challenges facing the consumer staples sector…

“The consumer goods industry is in turmoil, I need to act now.” – Stefan De Loecker, CEO of Beiersdorf whose main brand is Nivea.

The above quote and the consequent margin reset of Beiersdorf illustrate very succinctly the view we have had on the staples sector for the last few years.  There are multiple headwinds for the top line in this sector: lower volume due to a backlash against big brands and a rise of niche brands, low to zero pricing power (both with consumers and retailers) and slow and/or lacklustre innovation.  The result is that organic growth, which reached high single digit to low double digit levels just before the financial crisis, has been coming down to the 3-4% level.

To counteract this, companies tried to cut costs and increase margins.  However, ZBB (zero based budgeting) and severe cost cuttings led to a reduction in marketing and R&D spend, which in turn led to the aforementioned slower innovation.  Our belief is that if you are a consumer orientated company, it is imperative to invest in innovation and marketing to continuously keep your customers interested in your products.  However, many large companies took the alternative approach and are now paying for it with low or even declining volumes.

An excellent example is KraftHeinz.  Between 2014 and 2017, KraftHeinz’s margin expanded by close to 10% with the result that volumes deteriorated and were consistently negative during 2017/18.  This was not sustainable. At the full year presentation, we learned that some brands suffered so badly in the wake of cost cutting and changing  consumer tastes that their brand value had to be written down. Both Kraft and Oscar Mayer brands saw their carrying value reduced by a combined $15.4bn.  This was the big wake up call the industry needed.  We now expect to see companies increasing investment back to a more sustainable level in order to regain customers’ favour.  However, this additional spending will drive down margins.

As the chart below highlights, for most companies Y2 forward margin expansion estimates have come back from the red dots to the blue dots since the start of the year.  In the case of Henkel, Colgate and Beiersdorf, the market now expects margin declines over the next two years.  We believe this might also be the case for other companies and that over the next couple of years we’ll see further margin misses and disappointments.

Source: Bloomberg, Societe Generale, company data

So what lessons should investors draw from this?

At Saracen we have reduced our exposure over recent years.  However, we are not ruling out buying staples share again.  The issue is that most of the defensive staples are still trading on close to 20x Y1 consensus PE, with the caveat that the consensus “E” is probably too high.  On this multiple, we could not justify owning these shares at present.

The exception to the rule is Mondelez.  The company was spun out of Kraft in 2013 and represents mostly the old snacking business (biscuits, chocolate, gum & candy).  It had a slightly different strategy to most staple companies in the last few years in that it has invested heavily in innovation and has excelled at bringing new and exciting products to the market.  Also, when Dirk van de Put took over as CEO in April 2018 he made clear that his emphasis will be on top line growth and not margins.

Looking at Mondelez’s products you are forgiven if you think they are in terminal decline as everybody is trying to eat more healthily and cut out chocolate and sweets.  However, the snacking industry is growing high single digit in emerging markets and low single digit in developed markets partly due to time constraints and more on the go eating (longer commutes).  Also, snacking is sometimes seen as a reward as long as the main meals are healthy.  It’s highly correlated to GDP growth and has low private label penetration.  Mondelez is trying to capture this with innovation like chocobakery (combine Milka and Oreo), mindful snacking (smaller portion sizes) and improved ingredients (non GMO, wholegrain, gluten free, low sugar, high protein).

We also like the fact that private label exposure is very low and that Mondelez generates 40% of its sales in Emerging Markets, which grew close to 6% in 2018.  We bought the shares in June 2018 and have already seen a strong rerating as the market is getting more comfortable with the company’s strategy and business model.

Another approach is to invest in advertising companies as  the fall in the marketing spend of consumer staples companies, which so hurt the likes of WPP and Publicis in 2016-18, looks likely to be reversed.  Our holding in Interpublic (IPG) plays to this potential.  It is the 4th largest advertising and marketing services conglomerate globally.  Its flagship creative agencies include McCann Worldgroup and Lowe & Partners, while such firms as Deutsch, and Hill, Holliday are leaders in the US advertising business.  Interpublic also offers direct marketing, media services, and public relations through such agencies as Initiative and Weber Shandwick.  Its largest clients include General Motors, Johnson & Johnson, Microsoft, Samsung, and Unilever.  IPG has been gaining accounts and market share in recent years to the detriment of WPP and Publicis.

Like all agencies IPG suffered in 2017 amidst the slowdown in ad spending, especially in the Fast Moving Consumer Goods (FMCG) industries.  However, the company’s exposure to FMCG companies was relatively low compared to its peers and it therefore didn’t suffer as much.  In the recent past, it has been gaining new contracts, which, added to its sector exposure versus WPP and Publicis, sets it up as the main winner amongst the top 4 global advertising companies in our opinion.  In fact, during 2018 the company singled out that the FMCG vertical was one of the top performing sector for the group.  Management put this down to its ability to adapt to rapid changes and gaining contracts.  This should continue as the competition (WPP and Publicis especially) are only just starting to acknowledge the fact that their business models are to rigid and they will have to go through a transition period.  Something IPG did in the early 2000s, therefore being a decade ahead of peers.

Interpublic posted 2018 organic revenue growth of 5.5% and we expect this to continue into 2019-20.  Margins increased by 70bps and again, there will be more to come.  At 12x Y1 PE and with a 4.3% yield, we view the valuation as very attractive.

Consumer staples took a wrong turn, stepping away from a focus on brands and detailed, on-the-ground consumer research and paid heavily for it. Currently a reset of the sector is taking shape but it is too early to tell whether this will turn matters around sufficiently for the stocks to become interesting to value investors. There are still opportunities in this sector, either among some of the companies that stood apart from the rest and developed their brand or by betting on those firms likely to benefit from the return to an advertising and marketing focus among consumer staples companies.

Bettina Edmondston, Global Analyst at Saracen Fund Managers

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David Keir gives an update on his thoughts on the market and a new holding for the fund…

  • Markets have recovered from December lows, but sentiment remains cautious
  • Cyclical valuations are still attractive, despite the rebound in share prices
  • Company Management teams remain relatively upbeat, despite the gloomy backdrop
  • We expect more consumer staples companies to reset margins – the valuation of these stocks is at odds with company fundamentals
  • One new addition to the fund with the purchase of Asahi Group in Japan

Update on Markets

Our last quarterly report focussed on the significant value on offer in both markets and the TB SGIG portfolio.  We were astounded and frustrated that our portfolio of well-managed, global leading businesses could be trading on 10.7X Year 1 PER and with a forecast dividend yield of 4.8%.  Thankfully, markets have recovered from their December lows, but we observe that investor sentiment remains cautious.  The stock market recovery has been based on very low trading volumes and fund flows continue to be defensive in nature.  There remains no sign of irrational exuberance!

 

Cyclicals

Despite the sharp rebound, our research still finds more value in cyclicals stocks where share prices continue to price in a severe downturn.

Most of our companies have now reported their 2018 full year results and outlooks for 2019.  In addition, we have met or had conference calls with the majority of them.  In general, we have been pleasantly surprised by the resilience of the results, the relatively upbeat commentary and positive body language on display from management teams.  Whilst growth has clearly slowed, our companies are still expecting it to persist in 2019.  We outline below some highlights from management teams of our investee companies which highlight their cautiously optimistic outlook for 2019:

Evonik IR – “China is not as bad as everyone feared in October and November.  We have made a good start to 2019”.

Saint Gobain CEO – “Now, on the outlook, first of all and it’s no surprise to me given the good exit rate we are starting the year well.  And I would say that we’ll continue to see, globally, good trends for Saint-Gobain in 2019”.

Heidelberg Cement CEO – “We would expect that we will see result improvement and margin improvement in 2019.  We would expect that I – what I understand is that the consensus is on an EBITDA of 5.5% – that’s the number which we feel for the moment pretty comfortable”.

Schnieder CEO – “So, all in all, we target in 2019 an EBITA growth in absolute value between 4% and 7%. This would be achieved with a combination of a growth between 3% to 5% and an adjusted EBITA margin between 20 bps to 50 bps in terms of organic improvement”.

Given that backdrop, we still find the valuation of those companies anomalous.  Evonik, Heidelberg and Saint Gobain all trade on less than a 10X Year 1 PER and offer a yield in excess of 4%.

Another feature of the result has been the better than expected dividend announcements by a number of our companies.  We view this as a sign of management confidence in the future of the business.  For example, AXA which yields 6%, increased its dividend by 6%, Rio Tinto (6% yield) upped the full year dividend by 6% and announced a $4bn special dividend, and AIB (4% yield) increased its final dividend by 42%.

Consumer Staples

We have noted with interest the margin resets from a number of companies in the consumer goods sector, including Beiersdorf, Colgate, Henkel and Kraft Heinz.  We will address this topic in a separate blog, but we remain wary of the sector given the disparity between the high valuation of these companies and the anaemic growth outlook.  We would expect to see further companies having to reinvest more in their brands to try to drive top line growth.

Portfolio Update

We have recently added Asahi Group to TB Saracen Global Income & Growth Fund.

We previously owned Asahi in the fund but reluctantly sold the shares based on our “worst case scenario” analysis as we were uncomfortable with the Balance Sheet leverage (over 4X net debt/EBITDA) post acquisition of both SAB’s Western and Eastern European beer assets.

They have subsequently sold stakes in two businesses (20% stake in Tsingtao Brewery for $937m and a share in an Indonesian food business) and generated cash which has taken leverage down to a more manageable 3.0x (historic) and management expect it to fall below 2.0x by end 2020.

Asahi completely dominates the Japanese beer market with its Asahi beer and is turning this into a global premium brand alongside its recently acquired Peroni and Grolsch brands.  It is also a market leader in its soft drinks and foods division. Whilst the domestic business is dull, it should offer steady growth.  The real opportunity will be in the overseas division.  The valuation looks incredibly cheap (on an absolute and relative basis) as the shares trade on 14X 2019 PER.  Whilst the 2.2% yield is on the low side for SGIG, the pay-out ratio is only 30% today and will be increased from this level in the future which should lead to 9.4% dividend growth per annum over the 5-year forecast period.

We took advantage of the pull back in the shares (JPY 60 to JPY 46 over the last 12 months) to buy a position for the fund.

David Keir, Co-Manager, TB Saracen Global Income & Growth Fund

Important Information: The views and opinions contained herein are those of the author’s, and may not necessarily represent views expressed or reflected in other Saracen Fund Managers Ltd communications, strategies or funds. This material is an opinion piece and intended to be for information purposes only. This material is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Saracen Fund Managers Ltd does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Saracen Fund Managers Ltd has to its customers under any regulatory system. The data provider and issuer of the document shall have no liability in connection with the third-party data. The Prospectus and/or saracenfundmanagers.com contains additional disclaimers which apply to third party data. Regions/sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. Saracen Fund Managers Limited is Authorised and Regulated by the Financial Conduct Authority.

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Scott McKenzie, manager of the TB Saracen UK Income and TB Saracen UK Alpha funds, discusses the outstanding value and income opportunities he currently sees in the UK stock market.

UK Equities – It’s Time To Stand Up

Brexit continues to dominate the outlook for the UK equity market. As we write, chaos and uncertainty reign. However, times of maximum uncertainty often present the best opportunities and waiting for clarity may not be the optimum strategy right now.

We have seen global investors flee from the UK with several surveys now showing significantly underweight, negative allocations to UK stocks. The chart below taken from the BOAML global fund managers’ survey demonstrates with stark clarity just how much global investors loathe the UK market.

When we look at the income on offer from UK equities, the arithmetic becomes ever more compelling. Put into a global perspective, the main UK index now yields almost 50% more than the MSCI World. Whilst the UK has long been an income-seekers’ market, the current extreme positioning relative to history feels like a significant anomaly to us.

The UK index yield touched 5% recently and the income opportunities have rarely been greater in our view. If we compare the yield on equities to that available from government bonds, again the readings are at extreme levels. The chart below depicts the yield gap between UK dividend yields and ten-year UK gilt yields – these are now at post war highs.

To put the numbers into context, the historic yield on UK equities is currently above 4.5% whilst the yield on UK gilts is 1.3%; well below any current inflation expectations. Given the ongoing political chaos, we find it unfathomable that investors should wish to lend to the Treasury on such sparse terms and would argue that accepting the ‘risk-free’ rate has rarely been riskier.

An explanation for all of this may be that UK dividend payments are under severe threat. In aggregate there is no evidence to support this, particularly when one considers the huge weight of dividend expectation which falls on the shoulders of our largest companies, many of whom generate dividends in US dollars. The oil, mining and pharmaceuticals sectors stand out here along with giants such as HSBC.

Whilst the high pay-out ratio has indeed been a concern for UK income investors in recent years, the recovery in earnings for the resources companies in particular has seen dividend cover improve and the risks in aggregate reduced.

None of this makes us want to invest heavily in such large, mature businesses however, and many of them will struggle to grow dividends in the long run. Our strategy for the TB Saracen UK Income fund is unashamedly multi cap and our key objective is to continue to grow our dividends to shareholders at least in line with inflation. We believe that investing in a focussed portfolio with a bias to medium and smaller companies gives us the flexibility to achieve this goal without relying on high levels of income from a small number of huge companies whose best days are behind them.

2018 was a year of disappointingly negative returns from global equities, not just UK ones. It’s worth remembering that other major global markets fared even worse than the UK including Germany, Hong Kong and China. Many of the issues facing global investors are universal – rising interest rates, slowing economic growth and the threat of trade wars across key regions.

Despite this difficult background, we managed to grow income to shareholders in the TB Saracen UK Income Fund by 9% in 2018 and it is our firm intention to grow income again in 2019.  The historical yield on the Fund is over 5% today, a level we have rarely seen in the many years we have run equity income strategies.

The case for investing in UK equities has become increasingly compelling and the high dividend yields currently on offer pay investors for many of the risks taken. Whilst the worst-case Brexit scenarios are not pretty, valuations are already extreme and UK shares could recover significantly from here. Waiting for the clouds to clear may risk leaving it too late and missing the sunshine.

It’s time to stand up.

Scott McKenzie, Investment Director, Saracen Fund Managers

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Graham Campbell and David Keir, Co-Managers of TB Saracen Global Income & Growth Fund, discuss changes to the portfolio this month…

TB Saracen Global Income & Growth Portfolio Activity – October 2018 

  • 2 new holdings – Interpublic and Michelin
  • Funded by 2 sales – General Electric and SES

At Saracen, we take a long-term view and tend to trade very rarely.  However, our trading activity increases during periods of market volatility.  During October, we added 2 new positions in businesses where the recent share price movements have provided an attractive entry point – namely Interpublic and Michelin.  We have funded these purchases through selling 2 holdings where our worst-case analysis means that the risks of owning the shares are now too great – namely General Electric and SES.

Interpublic ($23.00)

Interpublic (“IPG”), is one of the world’s largest advertising and marketing services conglomerates (#4 after WPP, Omnicom, Publicis). Its flagship creative agencies include McCann Worldgroup and Lowe & Partners.  Interpublic also offers direct marketing, media services, and public relations.  Its largest clients include General Motors, Johnson & Johnson, Microsoft, Samsung, and Unilever.

IPG has been gaining accounts and market share in recent quarters to the detriment of WPP and Publicis.  IPG generates 60% of sales in the US and should be a main beneficiary of continued high consumer and business sentiment. Although US corporate tax rebates won’t necessarily be reinvested into marketing spend, there might be a slight increase, especially after the recent weakness vs. GDP growth.

The top 20 customers, which represent 25% of sales, have seen stronger growth rates in H2 and management is hopeful that this will translate into further market share gains with these clients.

IPG announced the acquisition of Acxiom’s AMS business in July for $2bn.  AMS is a data company that can “personalise ads”, i.e. it can aggregate, segment and model data according to audience buckets such as demographics, interests, purchase or lifestyle changes. One differentiating factor for AMS versus peers is its outstanding rating in privacy and security. Around 50% of the Fortune 100 companies are long term customers. AMS is a fee-based business with around 75-85% of revenue under long-term contracts and has grown around mid-single digit in recent years with 20% margin.

IPG thinks there are revenue synergies and a lift to margins as cross selling and a push internationally, which will work well with GDPR, will benefit both businesses. The deal is EPS accretive in year one even after dropping the share buyback for the rest of 2018.  Net Debt/EBITDA jumps to 1.8x this year but the company is comfortable with this and with the strong cash flow it will be almost net debt free by Year 5.

As the chart above highlights, the shares have de-rated significantly over the last 5 years from 22x to 14X Year 1 PER, and the yield has increased from 2% to 4%.  We have taken advantage of this to buy a position for the fund.

Michelin (€95.96)

Michelin produces over 187 million tyres in 68 production facilities in 17 countries. It is a premium player in the market and appears to be the price comparator for the sector. Unlike vehicles, tyres are rarely a purchase that can be deferred and 75% of the market is for replacement tyres.  We view the tyre business as a low growth utility.  There is huge pricing comparability at local levels and management respond to any competitor initiatives.  It is a zero-sum game as no additional tyres are sold, but industry profitability depends on competitor pricing behaviour.  The company will benefit from mix (larger tyres), tighter regulations, EV and a recovery in the mining sector.  Growth will rarely be dynamic, but this is a long-term leader and the recent underperformance provides a buying opportunity.  Given the strength of the BS and limited downside on Worst Case we bought the shares for the fund.

We funded these purchases through selling both General Electric and SES.

GE ($12.60)

We were forced to admit defeat in GE following unrelenting negative news flow in its power division.  As a reminder, this is a division that contributed $5bn to group profits and will now be loss-making in 2018.  Following a call with management it became obvious that the problems are more severe than we expected and will take much longer to fix than we forecast.  After our call, GE announced that John Flannery, CEO would be replaced with Jerry Culp, who is the senior independent non-executive director on the board.  Jerry Culp is well regarded in the market following his success as CEO of Danaher Group.  Given both Jerry’s initial comments that he will focus on de-leveraging the group, which in our opinion implied another dividend cut and our change of view on the recovery in the Power division, the worst case now became too severe and more likely and required a reassessment of our shareholding.  The share price appreciated significantly on news of the new CEO’s appointment and were sold into that bounce.

SES (€19.40)

SES shares have doubled from their recent lows in February 2018 following a change of management team, the core business returning to growth and the potential for them to be able to monetise their C-Band spectrum in the US.  As the chart above highlights, the shares have now re-rated to levels that are discounting material proceeds from the US spectrum auctions.  Given that the outcome of this is highly uncertain, the worst-case outcome is now very severe and therefore, we have sold the shares.

Updated Portfolio Thoughts

As we mentioned in our last blog entitled – “View from the Road – October 2018”, the outperformance of both the US market and growth stocks over the last few months had proven to be a difficult backdrop for fund performance.  However, the portfolio characteristics in the table below, highlight the value bias of the portfolio today which we believe represent a very attractive investment proposition for both existing and potential investors.

TB SGIG Characteristics vs. FTSE All World

  TB SGIG FTSE All World
Current PE 14.2 16.7
1Y FWD PE 11.4 13.7
Current Dividend Yield 4.2% 2.6%
1Y FWD Dividend Yield 4.5% 2.8%
Beta 0.95 1.0

Source: Bloomberg (31 October 2018)

 

Feel free to contact us if you have any questions regarding the fund.

Many thanks for your continued support.

David Keir (David@saracenfundmanagers.com)

Graham Campbell (graham@saracenfundmanagers.com)

Co-Managers, TB Saracen Global Income & Growth Fund

 Important Information: The views and opinions contained herein are those of the author’s and may not necessarily represent views expressed or reflected in other Saracen Fund Managers Ltd communications, strategies or funds. This material is an opinion piece and intended to be for information purposes only. This material is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Saracen Fund Managers Ltd does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Saracen Fund Managers Ltd has to its customers under any regulatory system. The data provider and issuer of the document shall have no liability in connection with the third-party data. The Prospectus and/or saracenfundmanagers.com contains additional disclaimers which apply to third party data. Regions/sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. Saracen Fund Managers Limited is Authorised and Regulated by the Financial Conduct Authority.

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Graham Campbell and David Keir, Co-Managers of TB Saracen Global Income & Growth Fund, discuss how clients may now be seeking to increase their exposure to ‘value’ style funds…

View from the road – October 2018

It was with slight trepidation that we started our regular round of client meetings.  We were brought up on the mantra that in times of good performance, it is important to communicate with your clients and in times of poor performance it is vital to communicate with them.  The recent few months have been difficult as investors have continued to favour growth as a style over value.  However, feedback has been surprisingly positive, and we sense that investors are now looking at increasing their exposure to “value” styled funds.

Value

Value as a strategy has been out of favour over the last 10 years.  However, we believe that over the long-term investing in “value” stocks should lead to outperformance.

As the chart below highlights, Value has outperformed Growth in roughly 3 out of 5 years since 1926, with an average annual price return of 18.9% for Value stocks vs 15.6% for Growth stocks.

Value vs Growth since 1926

Source: BofA Merrill Lynch, Ibbotson, Fama French

The outperformance of Growth against value since 2009 despite economic expansion is similar to the 1930s (after the great depression) and is an historic anomaly.

We suspect, that the current significant divergence in valuations of both value and growth stocks is causing investors to look at their portfolios and start to seriously consider tilting towards value.  As the chart below highlights, the underperformance of value versus growth has now reached two-standard deviations, which is a 5% probability event.

Value vs Growth since 1976

Source: Bloomberg

We have written a lot recently about how our portfolio has never been more “value” biased.  But from our conversations “value” can mean different things to different market participants.  Our definition of “value” is buying global leading businesses on a low 5-year Price Earnings ratio.

We have been staggered by the de-rating of many shares this year – both stocks that we own and ones on our watchlist.  This has provided opportunities to both top up our existing holdings which have performed poorly where we have strong conviction like DowDuPont, HSBC and Saint Gobain and introduce new names into the portfolio such as Carnival Corp, Interpublic Group, Michelin and Valeo.

The chart below, highlights how the P/E and yield have changed over the last 5 years of our recent purchase of Michelin.  The shares have de-rated to less than 9x 2018 PER and yield more that 4%.  We find that incredible value given that tyres are rarely a purchase that can be deferred, and replacement tyres represent 75% of the market.

Michelin

Source: Bloomberg

The outperformance of both the US market and growth stocks over the last few months had proven to be a difficult backdrop for fund performance.  However, the portfolio characteristics in the table below, highlight the value bias of the portfolio today which we believe represent a very attractive investment proposition for both existing and potential investors.

TB SGIG Characteristics vs FTSE All World

  TB SGIG FTSE All World
Current PE 14.3 16.9
1Y FWD PE 11.6 14.0
Current Dividend Yield 4.1% 2.5%
1Y FWD Dividend Yield 4.4% 2.8%
Beta 0.9 1.0
 Source: Bloomberg (23 October 2018)

 

Please contact us if you would like any further information.

Many thanks for your patience and continued support.

David Keir (david@saracenfundmanagers.com)

Graham Campbell (graham@saracenfundmanagers.com)

Co-Managers, TB Saracen Global Income & Growth Fund

 

Important Information: The views and opinions contained herein are those of the author’s, and may not necessarily represent views expressed or reflected in other Saracen Fund Managers Ltd communications, strategies or funds. This material is an opinion piece and intended to be for information purposes only. This material is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Saracen Fund Managers Ltd does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Saracen Fund Managers Ltd has to its customers under any regulatory system. The data provider and issuer of the document shall have no liability in connection with the third-party data. The Prospectus and/or saracenfundmanagers.com contains additional disclaimers which apply to third party data. Regions/sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change.

Saracen Fund Managers Limited is Authorised and Regulated by the Financial Conduct Authority.

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