Are UK consumers spending money at home?, September 2016

Carl Stick gives us an update on where retailers, financials and big pharmaceuticals are at post-Brexit vote and discusses his plans for the Rathbone Income fund, which is on the Chelsea Core Selection.

1996 is not a year I’ll forget easily, primarily because it was the year in which I got married and the one that changed the course of my career – I joined stockbroker Neilson Cobbold, which was then acquired by Rathbones.

Two years later, I transferred to London, where I became an assistant fund manager for the unit trust business, working alongside the well-respected manager, Hugh Priestley. In 2000, I took over the running of the Rathbone Income fund.

What do we do and how do we do it?

The fund is designed for generating total returns, often with some long-term target in mind such as retirement income, future healthcare costs, university fees and so forth. Our investment decisions reflect this philosophy.

We’re stock pickers and are not beholden to a benchmark. We do our own thinking. We prefer to own great businesses at fair prices. We’re investors, not speculators, so trading volumes are low. We want businesses that grow their earnings organically, generating dividend growth. Dividend income has proved to be a substantial part of investors' historic returns and income distributed by the fund has increased year-on-year for 22 of the last 23 calendar years¹.

We’ve imposed a strict definition of risk, which is the threat of a permanent loss of capital. We’ve developed a framework around three types of risk: business, financial and price. This is the bedrock of our process. Over the past decade, the other main development has been the increased use of our ‘suspect screen’, which signals red flags that we might have missed. This screen enhances our sell discipline. So, our process is a balancing act between the value, financial, and quality exposures in the portfolio.

What are we doing on a stock level?

Most of our companies reported their first half earnings at the end of July/beginning of August. In many cases, our meetings following these results will be our first contact with management teams post-Brexit vote, and should provide a fascinating barometer of business confidence.

Specifically, we’ll be gauging the willingness to invest and to recruit. We will be particularly intrigued by the health of our leisure and retail participants. Having voted to leave the EU, will UK consumers celebrate by spending money at home, or will the decision act as a brake on consumption?

We’ve been buying some Greene King (a pub and brewery company) and Halfords (a car parts and bicycles retailer). Shares in clothing retailer Next have sold off, but their market place is changing: Amazon will not go away, and the price of cotton is rising. Carnival is a lead player in the global cruise market, but how do we factor in the Zika virus or the threat of terrorism?

Financials are harder to crack. Sometimes we question whether we should ever invest in the banks and whether life assurers are just too difficult to fathom. But the dividends are attractive: HSBC yields 7%²; Lloyds Banking Group yields more than 5%³; and Legal & General has a 7% yield⁴. We should perhaps favour more ‘secure’ business models, such as credit provider Provident Financial (4.5% yield⁵) and Saga (5% yield⁶). However we invest, we recognise that there are business and financial risks, especially in an uncertain economic environment.

On a global level, we have become more confident with regard to pharmaceutical giants Roche and AstraZeneca, with the latter offering the potential for earnings growth through 2017.

The quality compounders have done the heavy lifting through the summer. RELX, British American Tobacco, Reckitt Benckiser, Unilever, and Bunzl hit all-time highs after the vote, as investors rushed for the quality life boats. But have these stocks now become too expensive? We’re loath to reduce our exposure, but we may choose to be less tolerant of valuations elsewhere in the FTSE 100 if prices continue to rise.

Getting great companies on sale

We’re feeling more optimistic now that the Brexit dust has settled, but this optimism has its foundation in our investment process rather than in any dramatic change in our views. There are still questions around the future of the EU, not to mention the even-more-monumental challenges that governments are facing: income inequality; mass migration; economic, social and political upheaval; terrorism; and political extremism to name but a few. Yet markets continue to pace higher.

Our intention, unsurprisingly, is to continue our focus on cash and dividends, and mitigate risk. Any volatility over the next 18 months will be our friend and we foresee there will be times when great companies are on sale.

¹Rathbone Income annual distribution payments, Rathbone data, 1993–2015
²–⁶Bloomberg, all yields as at 19 July 2016