Mark Dampier: What price equities when cost cutting does nothing for profits?

 

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The Independent Online

An interesting feature of investment trusts is that they have an inbuilt way of showing you whether they are in fashion or unloved. When trading at a significant premium to net asset value (NAV), this indicates a trust is in high demand. A trust trading at a discount suggests the reverse is true.

I am surprised at how many investors will purchase investment trusts at large premiums – a phenomenon recently seen with infrastructure trusts. That said, investment trusts can remain at a premium for prolonged periods. The Murray International Trust is a case in point.

Following a long period of consistent performance after Bruce Stout took over the trust in 2004, its discount gradually narrowed and moved to a premium in 2008. This peaked at over 10 per cent in 2013. It is now around 4 per cent after a few years of underperformance, though I believe it is still too early to buy the trust.

Mr Stout constructs the portfolio on a bottom-up basis (by analysing the prospects for individual companies). He recently outlined three main issues of concern. First, some areas of global government bond markets are trading with a negative yield (bond yields move inversely to prices, so when prices rise high enough, and yields fall, investors are in effect paying for the money they are lending to the issuer). He points out that this presents a significant issue in countries such as Germany, which does not have a culture of equity investment; many people are currently receiving no returns on their savings.

Second, he points to the negative returns from cash (after the impact of inflation), which he labels simply as theft. And third, he is concerned over falling inflation – while we are not yet seeing outright deflation, there is downward pressure on prices, with anaemic demand looking likely to prevail. Deflation could ultimately reduce corporate profitability.

Although Mr Stout must be one of the most experienced fund managers, he does not claim to know the exact consequences of these risks. But he does believe we are entering an environment where it will be extremely difficult to grow earnings and dividends. Companies have already done most of the cost-cutting they can, yet this can only do so much to improve profits and eventually they will need to invest for the future.

Reflecting this view, Mr Stout has reduced the trust's equity exposure to 98 per cent, from around 110 per cent in mid-2012 (his use of gearing has gradually been reduced as markets have risen). Over the past few years he has been far more cautious in his outlook for developed markets.

The US currently accounts for 15 per cent of the portfolio, with 11 per cent in the UK and 2 per cent in Japan. In the UK, with the general election looming, sterling weakness is a risk. It is a mystery to him why sterling has been so strong in recent years given the high budget deficit, but he believes the election could be the catalyst to change this.

Instead, the trust has held a bias towards Asia and emerging markets, which is why it has struggled slightly over the past couple of years as emerging markets have tended to underperform their developed market counterparts. He has invested 19 per cent in Asia and 18 per cent in Latin America. He expects the lower oil price should ease pressure on the currencies of countries such as Indonesia, India and South Africa.

Overall Mr Stout paints a bleak picture of the global economy and concludes that the only option is to continue holding a collection of businesses with good profit growth potential, trading at reasonable valuations. He has been recycling out of companies where valuations have become stretched, such as Nestlé, Johnson & Johnson, Novartis and Roche. Profits have mostly been recycled into existing holdings such as Nordea and Singapore Telecom.

Mr Stout joins a long line of fund managers who understandably believe the result of the current financial experiment will be a bad one. The bigger question for investors is if, and when, will there be an inflection point for a market correction.

I believe Mr Stout's capital preservation is prudent in this environment, while investors are currently receiving a yield of 4.2 per cent.

Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds in this column, visit www.hl.co.uk

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