James de Uphaugh: why shifting perceptions are good for UK stocks

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Merryn Somerset Webb: Hello, and welcome to the MoneyWeek magazine podcast. I am Merryn Somerset Webb, editor-in-chief of the magazine. It is 12th July 2022, and I have with me today James de Uphaugh, who is the manager of the Edinburgh Investment Trust, which I suspect quite a lot of MoneyWeek readers and listeners hold. James, welcome. Thank you for joining us today.

James de Uphaugh: Thank you, Merryn.

Merryn: Why don’t we start with you telling us a little bit about the trust? As I said, I think quite a lot of listeners hold it, but not everyone will.

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James: Yes. The trust is, like a lot of these trusts, long-established, and our involvement with this trust started at the tail end of 2019, where the board decided to make a change of manager. And as usually happens in these instances, there’s what in the trade is called a beauty parade and, in essence, there’s a huge amount of due diligence that goes through, and, in the end, the board alighted on the process which the team and I at, what was then, Majedie run.

And that seems like a long time ago, 2019, 2020. We’ve been managing it now for two and a bit years, and the numbers, they’re pretty respectable, frankly. The level of outperformance of the all-share over that period is about 10%, and obviously as the discount’s moved in a bit, we’ve made a bit of progress there. The share price is a bit further than that, but early days in our management of the trust.

But it’s a nice size. It’s obviously mainly focused on the UK equity market, which I think is at an unusually interesting juncture, if I’m honest. So really excited to be taking forward this trust.

Merryn: Let’s go back. What was the portfolio like when you got it, and how did you change it?

James: Yes, well, we did a bit of a root-and-branch restructure. I think that’s natural when you take over a portfolio, you want it how you want it to be. We changed approximately 60%, 70% of the portfolio. We used a transition manager, as you do in these instances.

And it was a weird time to be doing it because it was really March 2020, which, if you think back to that time, we had, as a country, decamped to working from home where you could and the like, as the advent of Covid came through. But the portfolio has shown itself, I think, resilient and more to the various chapters of Covid. We changed a lot, we obviously…

Merryn: What did you change? Sorry, what was it like before, and what got chucked out and what got put in? Because obviously it must have been a very odd time to be changing a portfolio.

James: Yes. I think if we look back, some of the portfolio names had a bit more leverage than I was comfortable with. We changed, for example, the property sector, we exited the property sector to a large degree, and really it’s all about putting the stocks you want and you feel strongly about over the next three to five years, rather than looking back at the past. And that’s kind of what we did.

I think in these instances, Merryn, you don’t necessarily look back. What you’re looking to do is minimise the inevitable cost when you make a transition, and then put the portfolio as you want it to be, because you’re managing the mandate, as a team, and you have a responsibility to outperform from there. And that’s what we’ve been about, if you like.

Merryn: OK, I’m not necessarily getting any further here, because what I really wanted to know was to get a sense of your investing methodology, relative to the previous managers.

James: In terms of our investment methodology, it is different, as it’s always different from a previous manager. What we like to do is we are deeply fundamental in our research. What we, as a team, are looking to do is put together a portfolio that has a number of themes, based off a number of styles. So we’re not value, we’re not growth, we’re a mix thereof.

And each stock, we’re looking to put together, as we’ve done here, a portfolio of approximately 50 stocks. And each of those is chosen very carefully, after a lot of fundamental research, where we’re really looking to work out what the three to five-year earnings power of the portfolio, of that stock in question, is.

And obviously, given that there’s a dividend angle to this trust, we also want to make sure that the company in question will produce the dividend flow in a natural way, and not in a way that, if you like, is something of a tithe. Because I think some of the higher-dividend-type portfolios that have characterised some trusts, actually the dividend is a tithe and something of a lead weight to the performance.

So we want to prioritise, if you like, a total return angle on that. If you look to the portfolio, we do have multi-themes, and we might want to touch on some of those in due course, if you wish.

Merryn: OK. One of the aims of the trust is to raise a dividend by more than inflation every year. That’s going to be tough this year, isn’t it?

James: That is going to be tough this year. The dividend decision is obviously a board decision, but I think, like a lot of boards, there’ll be a focus on what is a medium-term, underlying level of inflation, rather than, if you like, a now-cast level of inflation. But I think, as I’m sure you realise, that is a board decision.

Merryn: Is the trust able to pay dividends out of capital?

James: The trust is. The board took what I think is the right decision, to gently recalibrate the dividend back in the darker days of Covid, so, if you like, the cover on the dividend is reasonable and rebuilding. And when you look at the dividend payment, which is 24.8p on an annual basis, paid on a quarterly basis, that’s a pretty respectable level of dividend flow relative to the current share price.

Merryn: Yes. Let’s talk about the UK market as a whole, because you hold the view, quite rightly, given you run a trust focused on the UK, that the UK stock market is in a particularly good position at the moment. We’ve been writing about this in MoneyWeek for ages, saying it’s cheap, Brexit is time, it really is a great opportunity to invest in the UK, and that kind of didn’t happen. But now it appears to be beginning to happen. So tell us about why you think the UK market is very well placed.

James: I think the UK equity market has absorbed a lot. Because at the risk of going back to what now seems ancient history, we’ve had the Brexit vote in 2016, which made the UK equity market seem quite complicated to global investors. We obviously know that a big chunk of earnings from the UK stock market is earnt abroad, but still the political risk went up a notch, as people were working out what might occur.

And at the same time, obviously we saw earnings growth elsewhere being perhaps stronger than what the run rate was here. And I think if you look back over that period, you had pension fund de-risking, so negative flows on the supply side there. You also had, if you look at underlying flows from the retail environment, frankly there weren’t any. The action was elsewhere.

So, if you like, the set-up in terms of the positioning is relatively skinny as we come into this. You’ve got, in valuation terms, which is obviously critical if you look at things like the cyclically-adjusted P/E ratio, for example, which, as you know, is the average of the ten-year earnings, that’s a bit below the median, so it’s signalling OK value. And I think a number of the other angles on valuation are also looking pretty good.

And then, obviously, what we’ve got is the reality that, if you look at the structure of the UK market, you’ve got quite a preponderance of banks, you’ve got quite a preponderance of international energy companies, and also a decent chunk of miners.

And I think in each of those instances, actually, we’re in the foothills of quite a change in perception on those, and we could drill into those if you wish, which means that actually the UK equity market is, I think, unusually well-placed in this environment to perform relatively well. And I think, to me, it’s not surprising that actually the UK equity market has been pretty resilient to the more recent downdraft we’ve seen as central bankers tighten into slowing economies.

Merryn: Tell us about this change of perception of the miners.

James: Yes, I think the change of perception, let’s look at it through the lens of something like Anglo American, I think if we are going to, as we hope, transition, we are going to need a lot of metals, particularly copper, and a company like Anglo American, with decent existing copper projects, things like Los Bronces and this big, big peach of a project which is Quellaveco, are going to be able to grow their copper production pretty substantially.

And I think partly because it’s more and more difficult to get the permitting, find the right deposits, actually copper supply is very, very tight. So I think a company like Anglo American, with really decent broad spread of metals and a growing percentage for copper, is pretty well placed.

And I think there’s been a gentle change of perception, and I think the previous management, under Cutifani, where big drivers of this, there’s been a gentle change of perception that actually we do need these metals, and as long as the miner in question is producing them really responsibly, it’s actually a real force for good, if that makes sense.

Merryn: So you feel like the environment around ESG is changing quite fast, because only, what, a year ago, six months ago, you’d be hard pushed to get anyone to agree that there are any positive ESG characteristics to, say, the oil companies or the miners, etc. But that feels like it’s changed fairly substantially since the war in Ukraine began.

James: Yes, I think it has. And perceptions always change, and I think what has become very, very clear is where you get your energy from matters, and therefore a company like Shell, which is a big position in the trust, which has been gradually, as companies do, because these are long-duration businesses, reorienting its business towards less noxious forms of hydrocarbons. They sold their share assets to Chevron.

Companies like Shell, with very, very big positions in LNG are really strategically important for the world, and also they are producing prodigious amounts of cash flow, some of which will come back to shareholders, and some of which will be used to transition into new technologies, which will allow companies and customers to de-carbonise. So I do think there has been a change, and I do think it supports decent positions in these international energy companies.

Merryn: So it sounds like you are a believer in the idea that we’re in the foothills of a new commodity super-cycle, in that supply is constrained.

James: I think supply is constrained in some products. Yes, copper. Not necessarily iron ore, because there’s not much shortage there. I think, in the short term, we have got a bit of an issue with gas supplies, and, to a lesser extent, oil supplies. But I think one has to be very careful about which products one’s going after, and not generalise, saying it’s a commodity super-cycle, in my view.

And obviously the ones one actually invests in, one needs to be, I think, very careful that they’re very responsible in terms of their usage of… If you’re talking about copper, metals, energy and the like, because that is deeply in the responsibility of these companies.

Merryn: OK. Now, let’s go back to Shell, briefly. Is it 8% of the portfolio? You must be incredibly confident in the future performance of Shell.

James: Yes. I think we’ve got some Total and we’ve got Shell. And I think if you look at Shell as a business, it’s very broadly spread, it’s got fantastic positions in traded LNG, which it’s obviously making good money in. It’s spending, I think, the right amount in terms of investing in new technologies. And it also allows them to buy back decent chunks of their shares.

The dividend yield is at a reasonable level. And it’s a company with a decent safety record and the like. So yes, it is quite chunky at that sort of level, but I do think its spread and its diversification and history, and, frankly, its valuation… Because I think we could see approximately 40% of its market cap generated in cash over the next three or so years. So it is, I think, really quite cheap.

Merryn: And it sounds like there’s genuine inflation protection there.

James: Yes, I think that’s another nice angle to it, definitely.

Merryn: And the second biggest holding, again quite a big holding, 5%, is BAE. Tell us a bit about why you hold that.

James: BAE is a business which has, in the past, had various chequered points, but I think under the newish management, which is Woodburn, the execution, and remember these are big contracting projects, across all its areas has improved enormously. And that’s an important thing to think about.

And this is pre the issues we’ve seen with the land war in Europe and the like. So the core of the business was already beginning to work very well. They were very disciplined about their capital. They made some very good acquisitions from Collins and Raytheon.

And obviously what we’ve seen is the reality that there is a bit of a geopolitical notch-up in tension, not only what we’ve seen happening in Ukraine but I think also what is happening with China, and the rise in defence terms and defence spending that China is undertaking, and the implications for Taiwan.

And when you look at BAE, with its very, very broad spread across air, land, submarines, frigates, it is really, genuinely, multi-domain. It’s also got angles in space and cyber. And I think what you’re going to see is a business which has got increasing visibility in its order book.

I was listening, for example, to a replay of a conversation with the finance director of Thales, and this was just to illustrate the change in visibility which I think defence companies are undergoing, he’s been in place since 2012, and he was saying the change is enormous in terms of the scale of visibility that these companies have, or he has at the centre. They’ve literally got ten to 15 years of visibility.

And what is also interesting is what we’re seeing is an appetite to buy more of the same. And obviously, if you’re buying more of the same, it’s less risky to produce because unit costs tend to reduce, you get less risk. So I think the likes of BAE are going to see a very interesting multi-year progression.

You’d be looking at sales growth in the four to six range, with a little bit of operational leverage in there. And you get that for about 14 times, and you get a yield of about 3.5%. So I think BAE, and also I’ve got Thales and QinetiQ, is a very interesting share.

Merryn: It’s interesting, going back to the ESG angle on this stuff, again, six months ago anyone with an ESG overlay wouldn’t have touched any of these companies with a barge pole, but now they all slot very neatly into the S part of ESG.

James: Yes, I think just to preface it, at Liontrust, each of the teams has their own approach to ESG, within the umbrella of responsible capitalism, but I would say that there’s no sustainability without security, if you like, and there’s no security without defence capability. So it’s an uncomfortable reality which the West is having to wake up to. What we’ve seen in Germany is obviously most palpable. What we’re seeing in Japan is also interesting.

And I suppose there have been a lot of announcements, but actually perhaps there hasn’t been a lot of actual decisions on how it’s all going to be funded. But I do think we are seeing a notch-up in the defence, up the priorities, if that makes sense.

Merryn: Yes. Let’s talk briefly about the banks in the portfolio. You have quite heavy exposure to financials in the UK.

James: Yes. I think banks are interesting because there’s been a massive amount of muscle memory, I think, in banks. Because you just have to chuck up a chart of the period for NatWest, and that was obviously what was RBS over the period 2008 to now, to realise that it’s been pretty hard yards. But I think underneath the surface, what we’ve also seen, obviously, is these companies change immeasurably.

You’ve effectively seen regulators, quite rightly, push substantial amounts of regulatory capital into the businesses, and the net result is what is emerging is pretty strong businesses that, if you like, have been war-gaming pretty tough times for a long old time. You just have to look at those stress tests.

And these businesses have pretty high market shares, pretty good returns now, and trade at low valuations. And I think what the market, perhaps, is missing is that if you think about how a bank makes its money, in the old world, you used to make quite a lot of money on deposits, and then you also make money on your loans, and actually the deposit side hasn’t really been working, for all the obvious reasons. Whereas, more recently, obviously you’re seeing slight, gentle upgrades on that.

And so, for the first time in a long while, you’re really seeing the beginnings of growth in net income that isn’t really driven just by cost-cutting. And so what you’re seeing is profits likely to rise.

The good news is that those profits, in large part, are distributable, and so you’re likely to see, as we are seeing at the moment, decent amounts of buybacks and decent amounts of dividend flow. And you’re seeing that, for example, in NatWest Group, you’re seeing that in Standard Chartered, you’re seeing that in HSBC, which are the three we hold in the Edinburgh Investment Trust.

Merryn: We are running out of time, but I wanted to ask you, before we end, about inflation in general, because we mentioned earlier that the portfolio seems to have a degree of inflation protection built in. What’s your view on inflation over the next year or so? Are you a semi-transient person or a high-for-longer person?

James: I think we’ve got to get used to inflation running at a higher level than we’re used to. The rationale behind that would be de-globalisation, shortages and the like, but at the moment I think we’re moving at fever pitch for inflation, because what has also driven the excess, apart from the energy piece, has obviously been good price inflation, and I think with slightly tougher times, which we’re likely to experience, you’re likely to see that goods price inflation come off the boil.

So we’re at fever pitch at the moment, but I would sense that in a year or so’s time, we’ll come at an underlying rate of inflation that’s probably double what we’re used to, but not at the fever pitch level.

Merryn: You’re saying more 3% than 8%?

James: Yes, perhaps a bit more than that.

Merryn: So do you think that central banks are overreacting slightly, at the moment?

James: I think they’ve got a pretty tough job at the moment, but I think the Fed needs to… In the States, if you look at underlying inflation ex-energy, it’s running at quite a high level, so they really do need to tighten relatively aggressively. And I think they’re going at roughly the right pace.

Merryn: That’s amazing. Almost no one ever says that central banks are doing anything roughly right.

James: Well, I think they’ve got a tough job at the moment, and I think they’re doing their best. And I think they’re doing it at roughly the right pace.

Merryn: You might say they made their own bed.

James: Mmm.

Merryn: Mmm. James, thank you very much. That was absolutely fascinating, and also reassuring, I think, for investors in the UK. So thank you very much for joining us, I hope you will again in a year or so, and we can update where we are. Thank you.

James: Thank you, Merryn. I look forward to it. Thank you.