Alasdair McKinnon, Manager of The Scottish Investment Trust, explains why the surprises of the past year have been a gift for 'ugly duckling' investors.
At The Scottish, we’re contrarians to the core. So we aren’t dismayed when events don’t go as widely anticipated. After all, the prevailing expectation is the consensus view – and that’s exactly what we aim to avoid.
Last year’s Brexit vote is a good example. The outcome may have been unexpected, but it wasn’t a scenario we had ruled out. We always try to consider the potential impact of significant events, even when consensus tells us that they’re unlikely. Above all, our contrarian investment style is designed to benefit from change. Sometimes, those changes can be triggered by unexpected events.
This proved to be the case with the Brexit vote. One of its effects was to weaken the pound. As a global investment trust, we have most of our investments overseas. Sterling’s devaluation boosted the value of these investments when translated into pounds, to the benefit of our shareholders.
Meanwhile, our exposure to out-of-favour UK large caps proved beneficial. As most of their revenue is generated abroad, sterling’s weakness boosted their earnings and share prices. It also enhanced the dividend income we receive. This extra revenue enabled us to pay a special dividend this year – which resulted in a 40% increase in our total dividend.
Going against the grain
Our contrarian approach is grounded in the observation that people like to belong to a group. We believe this crowding instinct can work against the best interests of investors. Accordingly, we don’t attempt to follow investment fashions. Instead, we seek out investments in which we can foresee long-term upside. In doing this, we think that it’s crucial to ignore the emotions associated with past performance and to view each investment on its future merit.
Taking this contrarian stance requires lateral thinking and a willingness to ignore the prevailing views of other investors and companies themselves. This is because both markets and company management teams have a propensity for hubris in the good times and unjustified pessimism when times are hard. Standing apart from the crowd is often uncomfortable, but we are prepared to be patient.
The three categories of opportunity
We see three categories of opportunity. First, we have ‘ugly ducklings’ – unloved shares that most investors shun. These companies have endured extended periods of poor operating performance, and their near-term outlook can appear uninspiring. But we view their out-of-favour status as an opportunity and can foresee the circumstances in which they can surprise positively. Such companies often have a higher-than-average yield, providing an attractive income while we wait for our investment thesis to unfold.
Our second category consists of companies where ‘change is afoot’. These companies have seen a significant improvement in their prospects, which have not yet been recognised by the market. Often, they are disliked for historical reasons, with investors unwilling to credit signs of change.
Thirdly, we have stocks where we see ‘more to come’. Unlike the first two categories, these companies are generally recognised as good businesses, but we believe that the market does not fully appreciate the scope for further improvement.
Finding opportunities in pessimism
So where are we finding these opportunities? The Brexit vote established a strong negative consensus on certain sectors of the market, with one such area being the UK retail sector. The high street is facing challenges from online shopping as well as the perceived threat to the UK consumer from the decision to leave the EU. This has generated significant pessimism – and where there is pessimism there are often contrarian opportunities.
Marks & Spencer is an example that falls into our ‘ugly duckling’ category. Its shares were already unloved but fell further after the Brexit vote. However, the company has a new, experienced and credible leadership team, which is implementing meaningful change. The company’s strong brand and popular food offering should stand it in good stead as it implements simple but important changes to operations and products. And while we wait for these improvements to come through, the shares provide a strong, sustainable dividend.
We can’t control unexpected events. But we can avoid the crowded trades that are easily upset. By focusing on the overlooked and out of favour, we are confident change can be an opportunity.