Don’t worry if you missed last week’s virtual event with Stephen Anness, manager of Invesco Select Trust’s Global Equity Income Share Portfolio (IVPG ), you can watch the whole programme now!

In the recording, Anness outlines his approach to finding quality growth stocks around the world. These include ‘Mag Seven’ chip makers Broadcom and Nvidia as well as the UK’s 3i Group, his top holding at 6% of the portfolio. It’s been a successful strategy for the manager who took over in 2020, with underlying total returns of 52% in the past three years beating the 40% from the MSCI World index. 

Can’t watch now? Read the transcript

Gavin Lumsden:

Hello, good afternoon and welcome to ‘A World of Growth Outside the Magnificent Seven’, a one-hour programme brought to you by Citywire and Invesco. My name is Gavin Lumsden, I’m from Citywire. After a year in which seven US mega-cap tech companies stole the limelight by generating half the return from global equity markets in a frenzy over artificial intelligence, it’s a very good time to consider what were, perhaps, the other less crowded stocks providing the other half of the story. To help us with that I’m delighted to have with me Stephen Anness, head of global equities at Invesco and manager of the Global Equity Income Share portfolio of Invesco Select Trust. Stephen, are you ready to begin?

Stephen Anness:

I am, thank you Gavin. As you said, I thought we would spend a bit of time today, talking through the trust. Talking through the investment process, the team behind it and how perhaps, in a world where so much focus has been given to the Magnificent Seven, there are other opportunities out there and how we go about finding them and building the portfolio around that. That perhaps is a little bit more diverse, actually, than what has become a very concentrated market.

So just to briefly introduce the team. As you mentioned I’m head of the global equities team, have been here for 22 years now. Having spent the first decade of my career on the UK team, moving over to global equities in 2012. Andy Hall was one of the first recruits and I think one of the key things we’ve always tried to do as we’ve built the team is to have a quite a significant level of diversity of thought and approach. One of the things about Andy, in particular, is that he came from a hedge fund background. So with a quite significant short selling background. That’s really helped us in terms of wheedling out the difference between value stocks and value traps, for want of a better description.

If I think about Joe [Dowling, fund manager], he came from a bit of M&A, an M&A boutique before he came to us. Emily [Roberts, deputy fund manager] was on the sell-side as a consumer analyst and spent a lot of time analysing some of the more highly-rated luxury companies, which perhaps had been a bit of a weak spot for us historically. Moving on to some of the more recent recruits. Somebody like Yuyang [Zhang, analyst], she was an auditor for four years before moving to the sell-side. So having that qualified accountant within the team was something that we were missing. So the diversity of the team is really important in the way that we approach things in making sure we get a difference of opinion on the team.

Changes in 2019

Just to talk about the investment process and how we go about it. We took over this portfolio a bit over four years ago and the challenge at the time-, this chart here refers to the contributors to the tracking error of the portfolio at that point in time. So the end of 2019. So as I say, this is a few years ago now. You can see here that stock specific risk was indeed the highest contributor to tracking error, but there were three quite sizeable risks in particular, that you can see there. US dollar, European banking and European energy equipment and services. So in this situation the US dollar position there was actually a short dollar position. So the fund was effectively underweight the dollar. So I could tell you, in effect, how the fund would do if you gave me a set of characteristics that the market that day, that were performing well, for instance.

So this fund would perform well at that point in time, if value was working. If European value was working in particular, relative to the US, which is obviously less of a value market. So when we inherited the portfolio and I took over the team, we really changed a lot in terms of the investment process and we wanted a portfolio which could effectively work in different market conditions. Provided of course, that we get our stock selection and portfolio construction right, but a portfolio that had a chance of performing in different conditions. I think it would probably be fair to say we would generally underperform heavily momentum driven markets, but outside of that as we’ll come to talk about later, the stock picking doing the work provides us that opportunity.

So this was the same data as I showed on the previously chart, but as of the middle of February and you can see here that the stock specific risk is now much higher as a proportion of total tracking error and also, the contribution from any one particular factor has come right down. Also, the factors don’t tend to work in tandem. There’s a greater level of offset. So those factors that I showed earlier, that had the European banking energy services and then US dollar, those of course, tended to work together. Here we have a greater diversity. So again, it’s the stock picking hopefully, that is doing the work for the portfolio and for our end-clients obviously.

Growth and income targets

What are we trying to do and why have I just talked about some of those tracking error and process points? What we are trying to do here is build a portfolio into the trust that is what we would describe as a core proposition to clients. So what we really want to do is focus on not just dividends, but also capital growth as well. So you can see there in that middle column, that we want a starting yield in excess of the benchmark. We want dividends to grow faster than the overall market level. Now to do that, we may also own some stocks which don’t have a high level of dividend income or indeed, have any dividend income actually. Ultimately, we do want to outperform the benchmark over a market cycle, which we would say is three to five years.

So to do that we’re typically investing in around 40 to 45 stocks. Very much a strong focus on the bottom-up stock picking doing the work as I described and making sure that we avoid too much of the factor or corelation risk within the fund. So I touched earlier on those factor charts, but also, we map the correlation of the portfolio. So every stock is mapped versus every other stock, making sure that if there are pockets of correlation, we understand why they’re there and perhaps there are pockets of inverse correlation. When you look at that map, ultimately the spread of it is significant, ie, the companies are singing to their own drum beat over quarterly changes over ten-year periods. That’s important to us. As I say, we want the stock picking to work.

I wouldn’t want to sit here or in front of a client and say actually, it wasn’t a growth market, it wasn’t a value market, whatever it might be. We want to have the stocks doing the job. Ultimately, we think cashflows drive share prices over time. It’s important to us to find companies that have management teams that we trust, that are allocating capital well in high return projects. Ideally they’re paying us back a dividend, which can grow over time as the business grows. Perhaps as well, companies are shrinking their share count as well. Which as shareholders, done properly over time, that can really enhance your values as a shareholder, on a per share basis. So we think about things very much on a per share basis.

It pays to be active

Just perhaps diving into the market a bit now, this chart talks to what we define as persistency. So this is the contribution of prior year winners to the market in any given year. So you can see here, the red oval on the far right of this chart, this shows that after ten years of broadly positive bars, i.e., the contributors from the previous year, generally went on to add to market returns the following year. You can see there was a sharp reversal of that in 2022, ie, the things that had performed well in 2021, underperformed substantially in 2022. Then the same is true in 2023. You can see that’s a very heavily negative line. So what happened here was, again, what had performed well in 2022 underperforming in 2023.

So as an active fund manager, the opportunity set changed quite quickly through those periods. If you think about the end of 2021, you had very low levels of interest rates and rates were just starting to rise. You had the unprofitable tech boom and that had given a certain set of companies were very much the opportunity set at that time, at the end of 2021, 2022. In 2022, obviously, markets fell and generally, it was right to perhaps be a bit more defensive and to have avoided some of those more expensive companies. Then by autumn 2022, there was a lot of fear about recession and what that might mean. Again, that changed the opportunity set.

Regime change

So I think the point here is that actually, we think we may well be in a quite different regime going forward to that that we’ve been in post-GFC, where we’ve had very low interest rates for a long period of time. We may well be in a period where we have higher levels of macro volatility, call that inflation, interest rates, fiscal policy, geopolitics.

[TEN MINUTES]

That I think, has been partly what’s driven this chart here. You’ve had these very significant changes, partly related to what’s gone on in the macro and monetary policy environment that are driving markets. I think as we go forward, we may well see a continuation of that level of volatility. In which case, being active might well be the place to be. By that I don’t just mean having a high active share, I actually mean perhaps a higher level of turnover may well be a positive in the years ahead.

Certainly, I would argue in the last couple of years, being able to take advantage of those opportunities as they have come around and the market has certainly been additive to performance for the portfolio. We have a very open-minded approach and process in how we look at stocks. It’s very clearly defined – I don’t want you to get the wrong idea. It’s very clearly defined and we have some very clear guardrails and checklists, but we don’t close our minds to particular stocks or sectors.

We’re pretty broad across the market-cap spectrum as well. So wherever a stock may come from and we can touch on this later, if that idea hits certain criteria that we like, then actually, we may well consider it and whether it’s a financial or whether it’s a consumer staple, whether it’s a tech company. Over the last few years, we’ve invested in many different sectors and lots of different stocks, driven by the volatility in markets and depending on where the opportunity has come from.

What that led to and this is just the chart of the share price of the trust. The NAV [net asset value] and obviously, the MSCI World going back to the end of Q1 2020, which is when the new process was fully embedded into the fund. We made a lot of changes in that early 2020 period. I think over the course of that year, probably changed 60% to 70% of the portfolio. So quite a sharp turnover, but you can see that through that 2020 period to 2024. We were in the throes of the pandemic. We then had the vaccine news, which changed things, obviously. We then had the sharpest rate hiking cycle in 40 years. Concerns over a recession in autumn 2022.

What I’m pleased about is that the trust has generally performed reasonably well through most time periods despite how different those time periods have been. That’s allowed the NAV to perform over time, ahead of the MSCI World and delivered a good outcome for our clients.

AI play Broadcom

Now, I think perhaps bringing this to life with a couple of examples. You mentioned at the outset, obviously, there’s been a lot of talk about the Magnificent Seven and we’ve had some involvement in some of those companies. I joke that we’ve really only had one-and-a-half of the Magnificent Seven. On the right-hand side, a company such as Broadcom, which people may well know. It is a leading chip manufacturing business. It’s been around since the 1960s. I think the key here is that Hock Tan, the CEO, has been an incredibly astute capital allocator over time. So when we first invested in Broadcom, I would say that the market perception of this business was one of a bit of a hodge podge of assets. An almost on-market private equity rollup.

Actually, when you really take it apart, Broadcom is a series of quite duopolistic and oligopolistic markets. Critical infrastructure for networking and now, with the advent of AI, actually, the products that these guys make are also serving AI customers. So Broadcom and that’s one of the reasons that the shares have rallied so strongly from last year, is that actually, they now talk to a good chunk of revenue coming from AI. Particularly around the custom chips. Custom A6, ie, a chip which is designed for a very specific task. So if you think about-, Ed, who covers this at our place gives me the example of an Nvidia GPU being like a Swiss army knife. Can do lots of different tasks and perhaps a Broadcom custom A6 is a bit like a breadknife. It’s brilliant at cutting bread in a way that a Swiss army knife isn’t, but doesn’t do much else very well.

They also have a software business which then provides a very strong stability of cashflows, that allows the company to go and do further M&A and continue allocating capital. This has been a very successful investment for us. Not just from a capital appreciation standpoint, but also, the dividend has compounded very nicely over many, many years.

Rolls-Royce acceleration

On the lefthand side of this chart, we have Rolls-Royce, which is a very different business. I’m sure people will know this UK aerospace business. Nothing to do with the cars anymore, despite certain newspapers thinking that is the case. This was an example of a company not paying a dividend, but where we felt as though a recovery in flying hours, effectively, which is how we would monitor the improvement of the business.

So recovery in flying hours and also, the new management team grappling with some of the challenges that they inherited. I think it’s fair to say that there were some underlying improvements in the business going on anyway, but I think the new management team have really accelerated the cost out, the generation of cash. Fixing the balance sheet. You can see from that chart how well the business has done over that period of time. So it’s not just a civil aerospace business. There’s the business jets. There’s also a very robust defence business in there, Power Systems and of course, potential optionality around the small modular reactors, potential nuclear business. So I really want to highlight the open-mindedness of our approach, we’re able to find companies, I think, in different parts of the market.

So in Broadcom, it’s very much a tech business and AI and some software, but in Rolls-Royce its around incredibly important engineering skill. If you think about the near impossibility of disrupting a company like that. No matter how much money you had, it will be really hard to go and build a jet engine tomorrow. These engines then fly around for 40 years, earning in the new business model, a few per hour as they’re flown. So done correctly, this is a brilliant razor/razorblade model. I think the problem was, in the past it wasn’t done correctly and in the current times with the new management team, it really is.

So just to touch on performance. When we think about performance, as I said, I highlighted earlier, the importance for us of investing in companies very much with a bottom-up approach, making the idiosyncratic drivers of the portfolio be the most important thing. You can see here that broadly that is coming out here. So from an allocation versus selection effect, ie, where have we allocated money to.

Stock selection

You can see allocation is a very small addition to the portfolio. Really, the key has been stock selection. That’s true across geography. So whether that’s been the US, UK, Europe, generally selection has been the key driver of performance. Also true across industry as well. So again, whether that’s financials, industrials or information technology, it’s the stock selection that has driven the performance of the portfolio. That I think, is down to those guardrails and checklists that I talked about in terms of that team discipline, frankly, around idea generation and stock selection.

So just very briefly, I’ll touch on that element of the process. So how do we identify ideas? We have a very clear idea of the kinds of businesses that we’re looking for. Businesses which have generally performed well for us over time. We’ve got a very clear checklist of those. We then determine which are the most promising. We look at third-party systems as well, just to sense check our own views. An accounting quality score, that kind of thing. Profitability, cash generation. We then spend a lot of time on what we call the evaluate phase, which is a real deep dive into the business. Understanding competitive dynamics and modelling the business over the next five to ten years, to understand how that business can grow. So growth is really important to us on a per share basis. Growth in the business, growth in the dividend, growth in cashflows and making sure that, as I said earlier, the portfolio and the income from the portfolio are compounding.

So just the last couple of slides. This is the top ten of the portfolio. I think if you look at this, it’s very different to many of our peers and of course, very different to the market. That’s one of the things I think we touched on at the beginning. Really only Microsoft there in terms of the Magnificent Seven. Broadcom’s in there, which I would say has some similarities to those businesses.

[TWENTY MINUTES]

A broader range of companies in there, which I think provides a good level of diversification for clients. Away from index and peers, competitors.

3i is a retailer!

3i was the largest position you saw in the portfolio and I think this is probably one of the best examples of our process in action. This was a business that we came across in 2020. We felt it was really misunderstood by the market. The reason was, it was seen as a private equity business. Lots of leverage, high beta. Low quality. When we looked at this, we felt actually that was totally wrong and here we had a very high-quality business, driven principally by a key asset within the private equity portfolio, which is Action, a discount retailer in Europe and we felt that Action was growing really nicely and you can see the bar chart there. The total number of stores has moved along very nicely. The return on capital has been very high. To typically, mid-30% return on capital.

Really long runway from growth. Very low payback periods as they expand and generating a lot of cash. Critically for us, in this portfolio, a very nice starting yield. I think at inception, we had around a 3.4%, 3.5% dividend yield on this company. We felt, very good visibility for 10%-plus growth in the dividend over the next five years and, actually, I’d probably extend that further, given the runway for growth that the business enjoys.

Now, we can perhaps, touch on this later in terms of questions if you want to, but that’s the sector weighting that I would say is not really reflective of how the portfolio works. For instance, if you take 3i as an example, it’s 600 basis points [6%] of the portfolio and you can see there that the financials weight looks very high. 3i is captured within the financials bucket, despite in our view, being a discount retailer and certainly, when you look at the share price and the beta, it tends to operate that way. So perhaps we can touch on that later.

High quality growth

I would say a similar point here in terms of the geographic breakdown of the fund, we are underweight the US, but in a relatively concentrated portfolio, it’s only a handful of stocks that can move that. From a portfolio revenue perspective, actually, much more closely aligned. So, if I take that UK example, a 19% weight by portfolio weight to the UK. Actually, if you look at it by revenue, the portfolio only has about 4% revenue from the UK.

Then finally, just some headline characteristics of the fund. The price to earnings ratio of the portfolio is less than that of the market. The ROE, the return on equity, is higher. So, you could argue that’s a higher quality set of businesses. The dividend yield is higher than that of the market. I think it would be fair to say that we won’t be the highest yielding portfolio in the income sector. What I’ve tried to talk though today, is that approach on total shareholder return. Then also, as you can see there, lower leverage than the overall market. So cheaper, higher yielding, higher quality we think and less leverage is a good place to start.

What is your active share?

Gavin Lumsden:

Thanks very much, Stephen. I’ve got a few questions, but just to remind you, we’re going to be turning to you later on. So do send through your questions and we’ll look forward to seeing them. Stephen, you said it’s paid to be an active investor. One of my questions was answered on the screen, but could you just give us a couple of the numbers to back that up? What is your active share?

Stephen Anness:

Active share is 90%.

GL: Just to remind some people. That means you’re 90% different from the global benchmark.

SA: Yes, exactly. So compared to the MSCI World, we’re very different. We’re 90% different as you said.

GL: Then in terms of portfolio turnover, you mentioned in the first year you took over, you changed 60% of the portfolio. Presumably that’s not typical. What is a typical year?

SA: I would say a typical year is about 35%. I started managing money in 2004 and that 30% to 35% turnover rate has been a typical number for me for those 20 years. I would say that in the last year or so, it’s probably picked up a little bit. For instance, when we had the slightly shambolic UK government issues a couple of years ago, that provided a great opportunity to buy some very high-quality UK assets. For instance, we bought Next. A business we’ve followed for a very long time. We bought that company in that selloff.

GL: That’s a classic dividend compounder.

SA: Absolutely, yes. Incredibly well run, great management team. I can’t remember the exact total return we achieved, but we felt within six or nine months that it was broadly up with events. So, the rapidity with which these opportunities are coming and going, it has driven in the recent past, a slightly higher level of turnover. So maybe up to more like 45%. I would say 30%, 35% is typical for us.

Eight winners last year

GL: We’ve all heard of the Magnificent Seven, obviously, but your eight winners from last year were a mixture of Rolls-Royce, you mentioned. Semiconductor Besi, Broadcom, another semiconductor company. 3i, you mentioned. Nvidia, KKR, Microsoft. Celanese which I haven’t heard of before. US chemicals business. So quite a diverse group there. What so they say about the portfolio you’re running?

SA: I think if you were to come to the office and we sat down at my desk and went through our investment process and the discipline, the guidelines and guardrails and the checklist, you’d see that those companies broadly have a set of characteristics that are actually quite similar. So generally, I’d say they’re run by very astute management teams, allocating capital very, very well. They have some interesting growth opportunities ahead of them. In some cases, not all of them, there is a degree of self-help in terms of business improvement. Certainly, in something like Rolls-Royce and mostly definitely as well in Celanese’s case. You will also see a generally high level of accounting quality and cash generation, relative to net income.

Again, something like a Rolls-Royce, probably, doesn’t quite fit into that bucket, but certainly, something that we saw getting to that place. So those are really the key consistent things that we look for in all of the businesses. Growth on a per share basis. Ability to pay an attractive dividend at some stage and very astute management teams who, where possible, we want them to be as aligned to us, as shareholders, as they can be and ideally, own a good stake in the company themselves. I think as well, I touched earlier, on the correlation maps that we own and having a diverse portfolio is very important to us. So, as you mentioned, those companies are in very different sectors, doing quite different things.

Why we sold Nvidia

There was some corelation between Besi, Broadcom and Nvidia and that’s why, actually, with the performance of some of that wider semiconductor space, we’ve taken some profit there because we felt that that was becoming very much a dominant theme in the fund. Now, when those things were extremely undervalued, we felt more comfortable with that. When there’s perhaps certain areas of that theme of becoming more fully valued, we become a little bit more concerned about it. So, I think there are definitely consistent elements to them. That’s why I say, we are able to look across different markets and industries and find things that generally fit the patterns of companies that we’ve invested in the past, that have been successful and try and avoid the things where we’ve made mistakes. That’s been one of the key learnings of the team, is where have we made mistakes?  Let’s learn from those and try and codify them as much as possible.

GL: So, you’ve taken profits on Nvidia. Have you sold out completely, but held on to Broadcom?  Is it a cheaper version of Nvidia?

SA: Yes, we have taken profit in Nvidia. Full disclosure, we sold that too early. I think with hindsight, we didn’t expect the level of positive earnings revisions that Nvidia has seen. I don’t think anybody did to be fair. The change in the expected level of earnings and profitability from that business has been staggering. Driven by AI, which was a quite nascent thing relatively recently and has now become the thing. So, I think it’s probably worth stepping back a touch and saying, when did we first get into Nvidia? Particularly in an income fund. That happened in the summer of 2022. Nvidia fell about 60% from the end of 2021 to the summer of 2022. There were lots of fears around the datacentre business and the gaming business at the time.

Nvidia has done this many times in the past. It’s been through air pockets in its cycles. I think it’s fallen over 40% five or more times, in the last 20 years or so.

[THIRTY MINUTES]

So this does happen in this kind of industry. So that gave us a great opportunity. The way we look at things, we have all of the stocks that we cover and we have the dividend, the valuation, our expected return. Effectively, as the Nvidia share price went down in 2022 it went up our rankings in terms of relative attractiveness. So, we built our position up quite quickly in that summer. Now, with the shares then more than doubling quite quickly into 2023, we sold the position because we felt the valuation was okay, the total return was reasonable, but we had other ideas that we felt offered greater upside.

As I mentioned, there was a degree of corelation between Nvidia BE Semiconductor, Broadcom, and a couple of other things that we own. So, we exited the position. Now, Broadcom I touched on earlier. There is a good piece of the business which is AI related. It’s broadly also, I would think about it as an infrastructure business in terms of data transfer around the world. I think Broadcom talked to 99.9% of all internet and data traffic at some stage touching one of their chips in its journey. So obviously incredibly well embedded business. Think about that aspect of the business. Then you have the AI and then you have a software business as well, which provides a very stable set of cashflows. They recently acquired VMware which has recently closed. So that’s a business on a 5.5% free cashflow yield, attractive dividend, which has grown nicely over the years. We felt that was actually something which we were more comfortable maintaining the position.

How much further can 3i and Action go?

GL: 3i Group you’ve talked about a bit. It’s your top holding. On that chart, those blue dots, are those representing the purchases?

SA: Yes. I should have mentioned that. The purple dot was the original purchase and then the blue dots were adding to the position.

GL: So yes, you got it nice and early and you’re buying it before it shoots up. There’re blue dots quite recently. You’ve been adding to the position?

SA: Yes.

GL: 3I’s done amazingly well out of this Dutch discount retail business rolling out across Europe. How much further have they both got to go?

SA: Action is about 70% of the NAV [net asset value] of 3i.

GL: What do you think about that? Obviously 3i’s not trying to be a diversified fund.

SA: In the same way that you might own Tesco, which is a pure food retailer, pretty much, I think 3i is becoming heavily dominated by Action. I’m okay with that. It’s a wonderful company. Frankly, the more action, the better in my mind. Actually, they are buying more Action in, off some of the other partners. It’s about 70% of the NAV and I think from memory, there’s around 3,500 stores at the moment. We’ve done a lot of work looking at the total potential store growth. We think you can easily do 300 to 400 stores a year for at least ten years, probably more. That’s just in Europe. If you look at it on a per-population basis, what kind of population supports an Action store. That’s without even talking about the US, which I don’t know, I think they’re thinking about the US.

I think there’s a lot on their plate at the moment, rolling out pretty much a store a day, if you think about what I’ve just said. So, there’s a lot of business challenges to doing that. So, I think the US is a longer-term project potentially. What I’m talking about, in the next ten years or so, doesn’t incorporate the US at all. It’s highly cash generative. What that is allowing then, is that cash gets funnelled back to 3i. They can invest, obviously, in Action and deploying the stores. As I said earlier, they’re pretty fast payback on those stores. They don’t require a huge capital expenditure upfront. So that’s allowing a quite nice level of growth in the business. Then of course, that cash is getting funnelled back to the parent. Then that allows dividends to come back to us as shareholders.

It also allows a management team who have been brilliant stewards of capital over time, to go and invest in other parts of the business as well. So, they’re bulking up some of their-.

GL: The 3i managers or-?

SA: Yes, sorry, the 3i managers. So, the 3i management team are then able to go and invest in some of the healthcare assets, for instance, that look pretty exciting. Very small in relation to Action at the moment, but potentially, if you think of Action as a platform, what might the next platform for them be?  Could be some healthcare assets. I think typically, they’ve generated an ROE of 20%-plus on the investments that they’ve made over time. We’ve backed them to do that. So, we have a brilliant asset in action, that we think is undervalued and can grow for many years. Then we have a very astute management team able to allocate capital in to some hopefully, pretty exciting other avenues as well. So combined with the dividend growth, as I mentioned, we think for a portfolio such as this it really does remain a core holding.

Why do you overweight the UK?

GL: Sounds very impressive. Clearly could be a long-term holding. What about your UK overweight. 19% of the portfolio. How does that compare with previous years?

SA: The high teens weight in the UK. We’ve had an overweight in the UK for a while. 3i has been a reasonably big position for a period of time. It is not reflective of a view on the UK economy to be clear. I think I mentioned earlier that the UK revenue of the portfolio is about 4%, which is broadly in line with the market. If you think about the things that we own, 3i being the biggest in the UK, most of that is Action and then other parts of the business are certainly multinational businesses. There’s very little UK specific. Rolls-Royce again, I touched on earlier, they even report in dollars. They actually report in dollars, so the UK is a relatively small part of that business. The other UK assets that we own Standard Chartered, again Asian bank, listed in London. HQ here, but actually doesn’t really do any lending activities in the UK. Then finally the only real UK domestic exposure is Howdens, the kitchen manufacturer.

GL: So, it’s not a play on the UK economy, but the UK market is a good place to find cheap, good quality stocks. Is it?

SA: I started 22 years ago on the UK desk, as I mentioned. I moved to global about ten years ago. I would say that in the UK, there are some very cheap stocks, but as in many markets around the world, often those stocks are cheap for a reason. A lot of those companies are broadly the same share price as when I started my career two and a-bit decades ago. Some of them have paid a decent dividend on the way, but many of them lack the characteristics that I’ve talked about in terms of Broadcom or 3i. Businesses that are able to grow, reinvest and pay a growing dividend. So, I think in some of the sectors that are quite dominant in the UK, some commodity sectors. Some large-cap healthcare, telcos for instance. They’re hard industries to actually really generate decent levels of earnings and free cashflow growth.

So yes, there are some assets in the UK market that I think are appealing and we’ve touched on some of them, but I do think that the notion of looking at the UK and saying the headline PE of the UK market and the dividend yield of the UK market look appealing in the context of wider markets is a bit misleading. I do think some of those companies and significant index weights, some of those are most definitely what I would describe in value trap territory. They’re definitely cheap, but I think they’re cheap for a reason and you will probably end up with a broadly similar share price five years from now.

GL: So, the poor performance of the FTSE isn’t because investors are selling?

SA: I think it’s a constituent issue of what’s in the market, yes.

GL: Have you been surprised there hasn’t been more tactical allocation? I was thinking you were keener on the UK, but you’re not surprised that there hasn’t been more tactical allocation on the idea of the UK being cheap.

SA: No. If you look at it in the way I look at it, no. I think it’s rational, absolutely. I do think other markets, some of the US are getting extended and things. I’m trying to find 40 to 45 companies globally, out of thousands that we can look at. There are always interesting things going on. There’re some great companies in Asia. There’re some interesting companies in Japan. That has certain nuances as well. In America, once you move beyond some of the very large-cap, highly talked about companies, there’s some brilliant companies slightly further [marker 40:00] down the market-cap spectrum. Slightly amusingly, they’re often described as mid-cap, but they can often be 25-billion-dollar companies. Some of them are amazing with brilliant competitive advantages, excellent management teams and laser sharp focus on capital allocation and shareholder value creation. Those are the kinds of companies that we’re looking for.

What impact will the 4% dividend have?

GL: Last question from me. If shareholders approve the reorganisation of the trust, there’s currently four spokes to the select portfolio. You’re one, but if the reorganisation’s approved by shareholders, your bit, global equity income goes forward as the main one. At the same time, the proposal is that the dividend payout will rise to 4%. So more than it is currently. What impact will that have on you and the portfolio?

SA: To be clear, there’ll be no impact on me. No impact on the investment process. The dividend policy is very much set by the board, which is obviously independent and I think the board has taken the view that actually, providing a very clear and consistent dividend policy is right for shareholders. We will continue to manage the portfolio in the way that we have been doing for the last four years.

GL: Thanks, Stephen. Time for your questions. I’ve got some here, do send some more through if you can think of some. Talking of income, George Maluski’s asking, “What is the current yield on the shares?”

SA: At a portfolio level it’s 2.6%, but as just discussed, given the policy that the board have set, it’s 4% on the shares.

What mistakes have you learned from?

GL: You referred to learning from mistakes. We have a viewer who is quite interested to know what other mistakes made or lessons learnt while picking stocks?

SA: How long have we got? I think this is really important actually and thank you for the question. When I took over the team at the end of 2019, we had a lot of datasets and tools, I think now, that we didn’t have back in most of my career, frankly. We were able to look back to 2008 and say, what mistakes did we make? What successes did we have and what were the common characteristics from an operational standpoint. As I say, this went beyond just looking at industry or geography. It was very much the operating metrics of the businesses. So, there were certain things around using some third-party data in terms of just checking red flags on accounting quality and making sure accounting quality wasn’t deteriorating. So, I think that was one of the improvements we’ve brought in.

We’ve brough in some checklists which help us identify making sure that actually, there is evidence and we can prove why we think a business will grow at a certain rate, rather than just believing it. Again, touching on that point, I think perhaps we’ve become slightly more cautious, should we say, about the way that management might talk about how they’re likely to improve something. Is there evidence that this business can actually do what they’re talking about?  Has it done it in the past?  Have peers done it in the past?  Rather than just turning an average business into a good one. So, I think having those checklists and those guardrails in place has been really important.

How many companies do you look at?

GL: Following on from that, Edwardo Pinto is asking, “How many companies do you screen before selecting the portfolio? What metrics do you assess before getting in or out of a position?”

SA: This is a very important part of the process. We’re constantly looking for new ideas. I’m sure you remember Anthony Bolton, he always talked about turning over rocks. I think turning over rocks is a really important part of the process because it drives competition into the portfolio and it forces you to really think about the conviction in the portfolios you have, relative to new ideas. So, we have about 200 companies that we follow quite closely as a team. That we have models on, we have forecasts on and as I said, we have a valuation framework that then that all feeds into a big spreadsheet where we can then look at a live total shareholder return expected over three or five years. So that’s a north star, effectively, as a team.

Those things we know well, we have them under coverage. What is performing or underperforming in that cohort. That’s important to us. We’re also constantly doing screens for things like free cashflow yields, but companies where, as I say, there’ a high level of accounting quality, making sure that companies don’t have too much leverage. That’s something else that would feed into our screening. We’re very fortunate as well. We have most of the regional equity teams in Henley. We also have teams in the US that we can talk to about who they’re seeing. Companies they’re meeting. Ideas that they may have as well. So, there’s a huge raft of ideas. I think the critical thing is making sure that we fail things fast and we don’t waste time.

Going back to the previous question on mistakes and lessons learnt, failing things fast and saying no, we can do better and maintaining that very high threshold to getting into the portfolio has been very, very important in the last few years.

Are you a buy-and-hold investor?

GL: You spoke about the level of turnover in the portfolio. So, we’ve got a question here. “Would you say you are a buy and hold manager?” At one point you were talking about the increased turnover of the portfolio. On the other hand, right at the end, you were talking most eloquently about 3i and Action. Your average holding period seems to be about three years at the moment, do you regard yourself ideally as a buy and hold?

SA: I think it’s very tempting to say, I’m just going to buy some great companies and hold them forever and do very little with it. The academic data says that too much turnover is definitely a negative. I think there is also evidence that shows too little turnover can be a negative. What we’re trying to do and again, some of the lessons learnt were that actually, we cut some of our flowers too early and we watered the weeds. Actually, we’ve learnt from that lesson and constant thesis re-underwriting allows us to hold on to some of those real winners for a bit longer. I think though, we are open-minded. I used the example of next earlier. Next is a wonderful company, but there is a limit effectively, because of what it does, that it can grow at.

Once that is more fully reflected in the share price, there was no point us holding it any further. So, I’d say a business such as Microsoft, which has great opportunities to grow revenues very substantially, for a long period of time or a 3i, as I defined their opportunity set earlier, those are the kinds of things I think we’d buy and hold for a very long time unless the valuations really were fully reflective of that. I think there are other companies where they just don’t offer you that level of growth. So, you have to have some degree of valuation wiggle room, to allow you to hit that total shareholder return that you want. Once you’ve got there, I think there’s less opportunity. So very open-minded about where opportunities come from.

We’ve invested in some commodity businesses. Although, we generally don’t like them, but where we felt the valuations and the management teams were good enough. So ideally, we like to buy and hold, but we’re realistic. If the valuations of businesses are reflective of their characteristics and their opportunity set, then we’ll move on. There are always things for us to reinvest into.

GL: That sounds like a pragmatic answer. You mentioned briefly Asia earlier on. We’ve got a question here asking, “Got any investments in India?”

SA: No. We’re MSCI World. So, some of those EM areas are off limits.

Is the US over-valued?

GL: You also referred to the US, the valuations getting a bit extended. Could you elaborate on that?

If you look at the concentration of the market, obviously, the market has become extremely concentrated in a relatively small number of stocks. I think what’s also going on at the moment, if you look at the relationship and the correlation between momentum and growth and momentum and quality, it’s in the highest few percentile of history. So, it’s not just those biggest companies that are going up, it’s very much the quality growth sector as well, as a factor. I think it’s just indicative of momentum chasing a relatively narrow subset of the market. Many of those businesses are brilliant companies. I just think it’s interesting at the moment, the disparity between large-cap and small-cap is very wide at the same time that you’ve had generally low beta companies underperforming as well.

You’ve obviously got a lot more enthusiasm for soft or even no landing. So, sentiment is generally quite extended, I would say, in certain parts of the market. I think one of the things I’ve definitely learnt over the last 20-odd years is that macro forecasts tend to be wrong. I don’t know, they might be right this time, they might be wrong, but having a portfolio that is acting all the same, effectively, at the same time, is also quite a dangerous thing, I think. As nice as it may feel when it’s all doing super well. [marker 50:00] I think we’re just trying to be a bit more balanced and find the pockets of the market where we can find some really good companies, but as I say, at pretty attractive valuations. I think some of the valuations now, are at a point where it’s getting pretty hard to justify them, even for those super high-quality companies.

Is Europe looking more attractive?

GL: So, we might see the weighting to the US come down a bit. Is Europe looking more attractive?

SA: It depends on the business, I think. It really does. Actually, there’s some businesses and I mentioned earlier, some slightly smaller companies in the US. We’ve been buying two recently, that are in the 25 to 25 billion market-cap range. With 6% free cashflow yields, attractive dividends. We think very good growth prospects as well. Quite international businesses. One a bit more domestic than the other. So not necessarily. I think it’s beyond those relatively narrow leaders that we’re finding some of those companies. As I said, perhaps it’s down the cap spectrum. Perhaps it is in other parts of the world. Europe has some of the same challenges that I talked about with the UK. Often company managements aren’t perhaps as focused as you would want them to be on capital allocation and shareholders. Often, they are a little bit slower growth and perhaps a little bit less dynamic. So, one needs to be careful about where you invest.

GL: Still sticking to macroeconomics here, when do you think we’ll see interest rates start to come down?

SA: I think it’s fair to say we don’t base the portfolio decisions on the macro, but I will answer your question. I think we will see rates come down probably, a little bit faster than people think. From autumn, middle of the year, autumn.

GL: Take a while to get there, but when they come, they come.

SA: I think so. I think the market was too punchy in pricing in that many rate cuts, starting this month, I think. Obviously, those have been pushed out. I do think that the US economic growth, if you look at it, a lot of it has been driven by fiscal deficit. That is not going to be sustainable for too much longer, in terms of even expanding from where it is. It’s already a very significant level of deficit. So, I do worry that the private sector hasn’t really been joining in and what’s been driving this has been that deficit. Now, there will be challenges to that. I think also to me, it seems clear that we are now running out finally, of the post-Covid savings. Different cohorts across the spectrum have run those down faster than others. I think in general, most of those are gone now.

So, I think again, that support to the economy is moving away. Then finally, I think there are some signs that the labour market is staring to crack a little bit in the US. I wouldn’t overplay that, but I just think the idea that the labour market is super tight and will continue and will continue to be for the next number of years, I’m just not sure that’s quite true. I think we’re beginning to see companies talking about trying to improve margins, cutting labour and particularly, some of the small businesses that I think can often be more indicative of what’s going on in the real economy. Some of those small businesses are really showing heightened nervousness around employment expectations.

GL: Got another question from the audience. You talked about Rolls-Royce, one viewer is asking, “Are any other investments in defence companies?”

SA: No, Rolls is the only one.

Do you short stocks?

GL: Going back to your team, you mentioned you’ve got a colleague, Andy Hall, I think you said, with a hedge fund background. Do you short stocks?

SA: No. I should have said that at the time. We only do long-only. I think, when you think about the process, making sure that we avoid value traps is a really important part of what we do. I think perhaps, naïvely, as a long-only manager, I assumed when you’re a short seller is what you do is just kind the most expensive stocks and short them. Actually, Andy and I spent a long time talking about it and he said no, what you try to do is try to identify the weak business models. Then you go after them, even if they’re very cheap because they tend to get cheaper and they tend to underperform. Bringing that perspective into the team and the process has been really important in driving those changes and improvements to the process over many years. So no, we don’t do any shorting at all. We don’t do any derivatives, FX hedging, nothing like that. We’re very plain vanilla, long-only equity folk, but I think it was just an interesting perspective that he brought.

What has going global done for you?

GL: Last question, in your career you’ve gone from the UK to global. It sounds to me like you’re really preferring the global experience. Do you want to reflect a bit more on the opportunities you have globally versus the UK?

SA: The first ten years of my career were great. I loved it. I had a great time, great team, brilliant mentors. Martin Walker, who’s head of the UK team now and I worked with him for many years. He was massively helpful, as were the rest of the team. I was given the opportunity in 2012, to move over to global and I think what excited me was it just felt that is what active management should be. Basically, instead of investing pretty much with no limit and as I say, we have pretty much free reign across the market-cap spectrum, from $3 billion upwards. We can go across the MSCI World, developed markets. So, we have a huge range of options. Some great industries.

One of the reflections would be, I had to unlearn some lessons, I think. I came in 2002, to a UK team that had just seen the backend of the tech crash. So, there were various posters on the wall saying, ‘never invest in tech’ type stuff. Of course, actually some of those companies are amazing companies and Microsoft, whilst it took a long time to get back to where it had been in 2000, that’s been an unbelievable company for us in the portfolio for a long time now. The funny thing was, I think we first invested in Microsoft on about a PE of 11.

GL: What’s it now?

SA: Probably 30, 35 for this year anyway. I think I had to unlearn some of those lessons that actually, some of those businesses could grow faster and obviously, the importance of growth is key. That’s one of the things that we’ve touched on today. That growth can be found in many different industries, in different guises and I think the process is well set up to try and identify those across different industries and geographies.

Do you avoid any sectors?

GL: “Do you avoid certain sectors?  Oil and gas, tobacco. What part does ESG, environment, society, governance play?”

SA: We’re always very aware of the ESG risks. Broadly, I think tobacco is a no-go area for us. In terms of oil and gas, I think the importance of oil and gas in terms of the world economy is obviously still critical. We do have some investments there. We’ve done it in low-cost low-carbon footprint businesses. We won’t invest in tar sands and things like that. So broadly, following at Article 8 framework. If you broaden the question beyond the ESG specific things, we’re open-minded about most sectors. I wouldn’t say we won’t invest in financials. We then close ourselves off to something such as a 3i or we won’t invest in certain things. I don’t own it, Andy owns it in his portfolio, but something like Ryan Air. It’s an airline. Most airline are terrible, but actually Ryanair’s a really great business.

GL: There’s an exception to every rule.

SA: Absolutely. So, we’re open minded and I think you used the word ‘pragmatic’ earlier, that’s very much how we approach things. We’re trying to make the best of risk adjusted returns we can for our clients and we’ll turnover as many rocks and hunt in as many areas as we can to do that.

GL: Stephen, thanks very much for telling us all about it. Sounds really interesting and thanks for being with us today. That’s all we have time for today, but I hope what you’ve heard about pragmatic global investing has whetted your appetite beyond the Magnificent Seven. Thanks again so much to Stephen for joining us today. Look out for more of our investment trust programmes, but in the meantime, goodbye and happy investing.