Refined value investing: positioning portfolios for precarious times

Gary Moglione, Portfolio Manager of Momentum Multi-Asset Value Trust, argues that a defensive approach need not mean sacrificing upside.

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Gary Moglione, Portfolio Manager of Momentum Multi-Asset Value Trust, argues that a defensive approach need not mean sacrificing upside.

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It has been a strange start to 2022 for growth investors. After a surprisingly resilient performance through much of the pandemic once the initial shock was over, many stocks saw substantial sell offs at the start of this year. Prices plunged and the S&P 500 took one of its worst hits since the pandemic crash in early 2020.

Some companies have managed to recover but others are still trading far below the record highs they were at previously. This has been especially true for many of the businesses we saw go public in 2022.

The trigger for this sudden burst of panic appears to have been inflation. Perhaps buoyed by memories of the late 2000s, when ‘money printing’ policies similar to that of the pandemic, failed to bring about massive inflation, and combined with assurances from the Bank of England that price increases would be ‘transitory’, investors were initially sanguine about the threat of inflation as we emerged from the depths of the pandemic.

However today, UK inflation is at its highest level in three decades. The threat is alive and well, and combined with the risk of an escalating war in Europe, has spooked investors and the broader market. 

Hope for the best, expect the worst

The challenge for investors is that, unless you happen to work for a central bank, predicting interest rate rises is an incredibly hard pursuit. As too is working out how permanent inflation will be or what its impact is likely to be.

Consequently, the wisest course of action may be to expect the worst, hope for the best, and position your portfolio accordingly. In today’s world that might mean holding assets that can withstand inflation, but also not reduce your returns if it doesn’t occur or isn’t as damaging as some are predicting.

If you are an investor expecting the worst, a multi-asset solution – one that invests in a mix of assets, including UK and overseas equities, debt, specialist assets, and defensive assets, may be the desired solution to withstand inflation.

For an investor hoping for the best, a value-oriented approach to the market may appeal given that value stocks have tended to perform well during inflationary periods.

An approach that blends both these qualities is one focused on ‘refined value’ – harnessing a wide range of investable assets, each selected with a value consideration – a distinctive approach in the universe of investment trusts.

On one level this means appreciating the nuances of different asset classes. For instance, yields might be more important when looking at specialist assets, but price-to-earnings ratios could take precedence for equities.

Refined value also means not falling into the value trap. Superficial signs that a stock or other asset looks cheap aren’t taken at face value, meaning that our portfolio isn’t just the hodgepodge of banks and mining businesses we’ve come to expect from a lot of value investors.

Taking this approach has paid off in the past, with the trust managing to hit its target of the CPI +6% consistently over the past decade.

Inflationary tailwinds

Higher inflation is obviously not a welcome phenomenon. Employing a refined value approach, however, means that our asset mix demonstrates greater resilience to price rises. More traditional assets, like short-duration bonds and value equities, are blended with the more specialist, like royalties from music streaming and property and infrastructure holdings.

One example is Greencoat UK Wind. One of the key drivers of inflation is energy prices, and with soaring prices combined with strong wind generation in the UK so far this year, the trust is generating a lot of cash. Using the energy prices and wind generation to date, we believe the current full year dividend has already been mostly covered by Q1 income alone. With little prospect of a “normalisation” of power prices this year, there is a reasonable scenario of a 3x covered dividend (as summer months are typically less windy than Autumn and Winter). The board have committed to an RPI-linked dividend so the current elevated levels of inflation will result in higher dividends this year. In addition to a higher dividend, the excess cash is likely to be used for reinvestment into new assets that will bolster further future dividend cover.

Within our UK equity holdings, Phoenix Group was reintroduced to the portfolio after the share price de-rated from where we exited. With the shares now yielding close to 8%, we believe this was an attractive entry point. As interest rates rise, an insurance company’s liabilities in the form of life policies, decline. In addition to this, the company is now writing more new business than the decline in their legacy business, so we believe that the current dividend has the potential to grow from here.

We have numerous other examples in the portfolio of investments benefitting from inflation. Firstly, in the form of our property and infrastructure holdings, in which many have implicit inflation linked contracts that result in higher rents and higher asset values. Our specialist financials exposure consists of loan portfolios with floating rate or short maturity loans, so interest rate rises translate into higher income. Our music royalties exposure will also benefit as we expect increases in streaming subscriptions in an inflationary environment.

There are no guarantees here, but these are the types of businesses and assets that seem more capable of defending against the effects of inflation than others.

Of course, all this is assuming that inflation will remain a problem and interest rates are going to rise on a sustained basis. Those are both possibilities but not certainties. But that takes us back to expecting the worst and hoping for the best.

Our portfolio delivered on its goals even when value stocks were out of fashion and the wider UK market was producing extremely poor returns post-Brexit. Past performance is not indicative of future returns but it’s positive to know that we have been able to generate respectable returns, even when macroeconomic factors were working against us.

If those factors turn in our favour, whether that means value coming back into fashion or inflation-proofed assets performing well, then it’s plausible that a refined value approach will reap the benefits.