The strong performance of global stock markets over the last few years has left investors struggling to find attractively priced opportunties.

A sector with particular stand out performance is US Technology which has been dominated by high profile “new economy” names such as Facebook, Amazon, Netflix and Google (now called Alphabet), commonly known as the FANG stocks. Their performance has been driven by the long-term, secular trend of the increasing impact of technology and communication on our everyday lives.

Whilst we view the FANG stocks as expensive today, our research is finding significant value in some of the traditional US technology companies namely Cisco, IBM and Intel. These businesses enjoy many of the traits which we look for in an investment specifically, good market position, a strong and sustainable margin profile, robust balance sheet, cheap valuation and an attractive starting dividend yield of about 3%. These companies have been overlooked by investors because they have legacy businesses which still make up significant proportions of the group profits but which are either not growing or are in long-term decline. On closer inspection, however, it becomes apparent that these “old tech” businesses are slowly transforming themselves and, in time, like the FANG stocks, will benefit from the growth in connected devices, connections, data analytics and e-commerce.

Cisco is transitioning its business model away from a traditional “book and ship” every quarter model to a combination of hardware, software and recurring revenues. It is also now a global market leader in the fast growing software security market. IBM has created a “strategic imperatives” division which is growing at between 10% to 15% per annum and now represents over 40% of group revenue. Long-term, IBM hope to be able to monetise their significant investment in Watson, their supercomputer, which combines artificial intelligence and sophisticated analytical software for optimal performance as a “question answering” machine. Today Watson is predominantly being used in the Healthcare sector providing quicker and more accurate disgnosis for patients. Over time this will be rolled out across many different end markets. Intel is trying to evolve from a Personal Computer company to one that powers the infrastructure for this “increasingly smart and connected world”. The main strategic goals for Intel include the development of its data centre business, where its microprocessor chips help power the cloud servers of Amazon and Microsoft, as well as the Internet of Things division, where one of the growth drivers is powering the computers running autonomous cars.

Additionally, these businesses may also stand to benefit from the policies of Donald Trump, the new US President. They all have significant amounts of cash on the balance sheet which is currently held outside the USA for tax purposes. A change in the legislation may allow companies to bring this cash back to the USA for a one-off penalty. For example, Cisco currently has $60bn of gross cash which is currently held overseas. This represents 40% of the market capitalisation of the company. If this cash can be successfully repatriated, we would expect shareholders to benefit from incremental returns through increased dividends or sharebuybacks or, even, further investment in the business. These businesses would also all benefit from a signficant reduction in the corporate tax rate from the current 35% rate to the proposed new tax rate of 15%.

David Keir
Executive Director, Saracen Fund Managers Ltd. and Co-Manager of the TB Saracen Global Income and Growth Fund

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My colleague, Scott McKenzie, wrote a blog in December entitled ‘Santa’s Black Friday Bargains’. Sticking with that theme, I have been examining a sector very much out of favour at present but one where the fundamentals look solid. That sector is house builders.

At first glance it is easy to put forward arguments as to why investors should eschew the sector: weak consumer confidence, an end to low interest rates or, heaven forbid, ‘Brexit’!

Having outperformed the market consistently for the previous five years, housebuilders underperformed in 2016, returning -19% versus a 17% increase in the FTSE All Share (Total Return). It could be argued that profit-taking was a factor but, without a doubt, a move away from domestic, UK cyclical stocks into the larger, multi-national FTSE 100 companies played its part.

Before going on to discuss the rationale for our positive view of the sector, let’s try and rebuff the bear case for not investing in the sector. Firstly, is consumer confidence really so bad? The data, up to this point at least, shows the UK consumer is still feeling relatively upbeat about life which flies in the face of the weakness of share prices. Crucially, the employment rate is at an historic high. Secondly, interest rates, as we all know, are at historic lows and will have to rise at some point. That said, when they eventually do start to increase (which we believe will be some time away), it is likely this will happen in a measured way. It is often the case that it is cheaper to buy than rent if the minimum deposit can be raised. Even with increasing rates, that is not likely to change. Lastly, the great unknown, and the reason most often trotted out by bears of the sector, is the result to leave the European Union. At present, it is impossible to know which form Brexit will take but what shouldn’t be overlooked is that the majority of those who voted opted to leave. As far as those individuals are concerned, they got the result they were looking for and, therefore, it is business as usual.

Now that the bear case has been examined, it’s time to put forward the case for the defence. We continue to see upside in UK housebuilders due to the combination of strong demographics, poor historic supply and unprecedented Government support to name but three. When you factor in modest valuations and strong balance sheets, it is clear as to why our view differs from many others.
At present, the UK is not building enough homes to keep up with demand. In all honesty, it can be argued that the country has not built the required number of homes for many years. The official
Government target is for 250,000 new homes to be built every year but output between 2004 and 2014 averaged 160,000 and last year somewhere between 170,000 and 180,000 homes were constructed (see below for quoted sector completions since 1997). This chronic shortage of stock will not be rectified for quite some time.

The UK Government is keen to get more of its citizens onto the housing ladder and, consequently, there has been unprecedented support for the industry. Their flagship policy is ‘help to buy’ where the Government will lend up to 20% of the cost of the property (40% within London), leaving first time buyers only requiring a 5% deposit. Additionally, no fees are charged on the Government’s portion for the first five years.

Local authorities are shortening the time taken to approve planning permission for new homes and this, allied with land prices falling over the last three years, is helping to maintain the margins for builders. There is little competition at present for land due to the length of the existing land banks held by companies (on average 5.4 years) with no sign of the pricing situation changing. The last factor which is crucial in maintaining our positive position towards the sector is the ratings of our stocks. We have three house builders in the UK Alpha portfolio – MJ Gleeson, Berkeley Group and Galliford Try. The chart below for Berkeley Group shows earnings estimates over the course of the last year (in red) versus the performance of the shares (in blue). It is clear to see the share price has materially lagged earnings.

Although our three stocks reside in the same sector, they are very different companies. At one end of the spectrum is MJ Gleeson, the North of England, affordable house builder. At the other is Berkeley Group, focused on the mid to high-end South East of England market. In between the two lies Galliford Try.

Each of the companies shares some common traits – modest ratings, strong balance sheets, high dividend yields and impressive margins. If, as we believe, these stocks can navigate the next twelve months without any problems, a re-rating from current levels should be achievable.

Craig H. Yeaman
Investment Director

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I wonder if you do the same thing as me, that is stocking up on cleaning or personal care products like toothpaste and shampoo or even some foods and treats when they are on offer?

Sometimes I end up with lots of different toothpastes in my cupboard while other times I’ve run out and have to go out hunting for the best offer on the high street. This made me think, if customers keep looking for bargains – bearing in mind you can’t really increase your consumption of toothpaste or shampoo indefinitely –how will these so-called staples companies generate their profits in the future?

Defensive stocks have performed strongly over the last few years. This is especially true for consumer staples, i.e. food, beverage, household and personal care companies such as Nestle, Unilever, Coca-Cola, Colgate or Kimberly-Clark. One of the main reasons behind the strong performance is that investors who rely on a steady income from their portfolios had to shift from bonds into what we call bond proxies. The yield requirement could not be met with traditional bond investing so we have seen a shift into those equities with reliable dividend payments, such as consumer staples. The large inflows have driven-up their share price substantially over the last five years. In fact, the price performance is very strongly correlated with the inverted bond yield and has increased over the last few years:

However, the underlying fundamentals of these shares paint a very different picture. Organic growth rates are slowing, both in the food space, but also in Household Goods and Personal Care products

The slowdown in volumes is due to consumers switching away from multinational products. In emerging markets the trend is towards locally produced niche products, especially in personal care. In developed markets, private label continues to gain market share from branded manufacturers. Additionally, in high inflation countries (e.g. Brazil) where the multinationals have had to increase pricing substantially in order to offset the currency impact, a loss in sales volume has been triggered. In recent months, the volume loss has been higher than price increases resulting in negative organic growth rates.

Even in the UK we have seen attempts of large price increases in the wake of the weak Sterling after Brexit. One just has to remember, the spat between Tesco and Unilever or the ‘wider valleys’ of Toblerone.

Furthermore, staples companies have benefitted from a decline in raw material prices over the last 2-3 years. Although margins did improve by about 200bps in the last ten years, this equals an average margin increase of 20bps p.a. In future, we expect raw material prices to rise and become a headwind hampering the already pedestrian margin expansion we have seen over the last ten years.

Raw material prices is just one factor which will contribute to rising inflation. We also see labour costs rising on a global basis. This will automatically lead to pressure on staples companies to increase pricing. However, as we’ve mentioned earlier, pricing often results in lower volumes and often the negative volume decline is higher than the positive pricing effect.

In our opinion there are many headwinds on the horizon for these staple companies, not least a recovery in bond yields. At current hefty valuations, the risk of a continued correction and money being pulled out of bond proxies is high. We are happy to avoid these shares for the time being.

Bettina Edmondston
Global Investment Analyst

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On a recent trip to my local grocery store, I noticed a shift from the ever-ubiquitous sugary confectionaries which typically reside by the checkout.

In their place were drinks and snacks labelled as ‘sugar free’, ‘paleo’ and ‘fuller for longer’. In my sugar-craving state, I went in search for something far less virtuous; a can of coke. However, on discovering the Coca Cola section I was surprised not to be greeted with a sea of red, the classic Coca Cola packaging. Instead I was welcomed to a wide range of apparently, healthier alternatives, for example; Coca Cola Zero (sugar free) and Coca Cola Life (made with stevia, a zero-calorie plant based sweetener). This sparked a thought in my mind: could this be the demise of Coca Cola?
Founded in 1886, and one of America’s most iconic brands, Coca Cola has long been a firm favourite in households across the globe. With an extensive corporate history spanning over 125 years, the shares have typically been viewed as a low-risk, high-dividend option. The company has paid dividends since 1920 and increased this in each of the last 54 years. Over the last 5 years the shares have rerated from 17x to 22x. However, with a rise in health conscious, green juice guzzling millennials, and a tax on sugary drinks set for 2018, is there even a future in such longstanding brands?

Since 2012, earnings forecast has fallen almost every year with 2016 earnings expectations 11% below the 2013 forecast at just $1.98. With such negative growth in the business, how can the dividend yield sustainably be kept above 3%? Put simply, it cannot. In order to keep the dividend, yield around 3%, the payout ratio increased from 35% in 2011 to 79% in 2016 while net debt/EBITDA more than doubled from 1x to 2.2x.

By levering up and increasing the payout ratio on a large scale, there is no room for mistakes. A back-up in bond yields would likely cause significant underperformance and with interest rates in the US set to rise, this is not a sustainable situation.

Overall, the underlying growth outlook for sugar-rich drinks is stagnant at best. With lack of growth and a new market saturated by healthy alternatives, demands are changing. Moving forward, economically cyclical businesses are outperforming expensive defensives and the market is finally beginning to look beyond expensive staples.

We have sold almost all our defensive holdings and have been positioned for this shift in the market for a while. Accordingly, our performance has benefited from this move.

Bettina Edmondson (Global Investment Analyst)
Megan Heather-Cooley (Fund Specialist)

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It did come as a surprise to us and many other people that Donald Trump won the presidential election in USA.

Initially markets reacted negatively, especially in Asia. However, by the time the European markets opened Trump had made his acceptance speech and calmed the nerves with his very toned down rhetoric. At the end of the day European and US indices finished the day up and the US$ was down only slightly against Sterling and the Euro.

What implications does this have for our portfolio, the TB Saracen Global Income & Growth Fund? Do be honest, not a lot. We are very bottom up driven stock pickers. Our process leads us to invest in market leaders that can grow top line, earnings and dividends and will experience a revaluation over the medium term. While we are not driven by top down macro we do expect the global economy to grow at low rates for the next few years. We are not concerned about a global recession.

Going into the election we had the most cyclically positioned portfolio in decades. We started selling bond proxies in the staples space about 18 months ago as we believe these shares are too expensive for the growth they offer. We also expected bond yields to rise, regardless of who would win the oval office. This theme has started to pay off and we expect it to gain momentum in the coming months.

On the other side the fund is pretty fully weighted in financials, healthcare and industrials. Financials is almost a pair trade to the staples theme as rising bond yields will help the fundamentals of banks and insurance companies. Banks have been largely recapitalised, have less leverage and bigger capital buffers than they had in the last 10 years and are out of favour with investors. We believe at current valuations these shares are attractive investment opportunities for us.

Our exposure to healthcare has been increasing since the start of the year. Pharmaceutical shares have not reacted like other defensives bond proxies. The main reason was the concern over a Hillary Clinton presidency and a consequent crack down on drug pricing. However, we were less worried about a potential political intervention as Clinton would have not had the support from the Senate or the House of Representatives. We felt that healthcare stocks had been overly penalised. Again, our holdings are fundamentally solid companies, with strong pipelines and attractive valuations. We would have expected a positive contribution to our performance over the medium term even with a Clinton presidency.

Industrials will benefit from increased infrastructure spending, which was a policy for both candidates and should happen not just in the US but also in Europe.

Saracen Fund Managers has a very rigorous process in place. We have a long-term investment horizon and forecast out 5 years, which helps us identify things that the market is not looking at today. Our analysis is bottom up and we try to see through the noise. As was the case with Brexit it is important to stick with your process and not panic. We believe our portfolio is full of fundamentally strong and attractively valued investments that will deliver regardless who is running the largest economy in the world. We only slightly tweaked our portfolio in the aftermath of Brexit and we are not intending to change it now after the US election. The point of having a process is to stick to it. This has proved to be a profitable approach for us. It also helps our clients to structure their portfolios and have visibility in any market condition.

Graham H Campbell – Chief Executive Officer
David M Keir – Head of Research
Bettina Edmondson – Global Investment Analyst

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