Perpetual Income & Growth (PLI) has announced its annual results for the year ended 31 March 2017. During the period, it provided an NAV total return of 9.6%. It’s chairman, Bill Alexander (pictured), says that Although this is satisfying in absolute terms, it is less so when compared with the 22.0% return posted by the FTSE All-Share Index, the Company’s benchmark. Also, the discount of the share price to the underlying net asset value widened during the year, from 5.1% to 9.7%, reducing the share price total return to 4.2%.
Positive contributors to performance
In terms of performance attribution, the chairman says that the shortfall in the relative return for the year derived mainly from a combination of holding few resources stocks, which performed strongly in the first half of the year, the downgrading by the market of domestically focused companies following the Brexit vote and certain stock specific issues amongst portfolio holdings. The manager, Mark Barnett, highlights that not holding any mining sector stocks, HSBC or Royal Dutch Shell, held back performance as they all performed particularly strongly. Regarding the mining stocks, Mark says that their absence benefited the portfolio’s performance over the previous two years, but he says that the recovery across the sector in the past year meant that the portfolio missed out on one of the major positive trends of the past twelve months. In his view, control of supply has improved following the shock of the 2011-2015 downturn, but demand growth in China remains under pressure and the sector now looks vulnerable to a fall in the prices of certain key commodities.
Mark says that holdings in the tobacco sector again delivered a strongly positive contribution to performance. He says that, despite a lack of enthusiasm for “bond proxies” that prevailed for much of the period, the sector was boosted by corporate transaction activity, with a proposed merger of two of the portfolio’s largest holdings. Reynolds American accepted a cash and shares offer from British American Tobacco, creating a combined entity which Mark says is well positioned to exploit next generation products, particularly the US e-cigarette market.
AstraZeneca also performed strongly over the period, boosted by its US dollar exposure. Its chief executive Pascal Soriot has characterised 2017 as a potential “inflection point” for the company’s return to long-term growth, with the upcoming launch of several “life-changing” medicines for cancer, respiratory and metabolic diseases built on the “solid foundations of a science-led pipeline”. Mark comments that the European pharmaceutical sector as a whole did not perform well in 2016, as the market focused increasingly on the risks associated with new product trials, the overall pricing environment in the US and the challenge of replacing mature drug portfolios. Mark’s view on the long term outlook has not changed. He says that the de-rating of the sector suggests that major companies which succeed in bringing genuinely innovative drugs to market could see a meaningful boost to their prices and the performance of the portfolio’s holdings in the sector.
Other significant positive contributions to portfolio performance came from the holdings in BP, Compass, G4S, Homeserve, RELX and Rentokil Initial.
Negative contributors to performance
Mark says that the portfolio’s holdings in companies particularly exposed to the fall in sterling and perceived challenges to the UK economy performed poorly in the aftermath of the referendum. He also says that the stock market was also inclined to de-rate companies which warned of lower profits. Notable amongst these was PLI’s holding in Capita, which he says fell sharply in value as it downgraded full-year earnings forecasts, blaming a range of issues including delayed client decision-making since the EU referendum. The company later confirmed the departure of its chief executive and expects 2017 to be a “transitional year” for the business, as it completes a number of disposals, embeds internal structural changes, and re-positions for a return to growth in 2018. Mark says that The projected disposal of Capita Asset Services should reduce balance sheet concerns and allow the business to focus on its fundamentally strong outsourcing business.
The holdings in the travel sector, easyJet and Thomas Cook, warned of the negative impact of weaker sterling and were additionally impacted over the period by concerns over terrorist activity and by air traffic control strikes. The share prices of both companies rallied in the first quarter of 2017, as they confirmed more positive trading updates than had been feared by the market and on the back of some renewed sterling strength.
BT detracted from performance. Its shares suffered a sharp sell-off after an update on accounting irregularities in its Italian division, further exacerbated by a profit warning from the company that highlighted a more challenged outlook for UK public services contracts. Mark says that, further to this, issues with Ofcom over its Openreach subsidiary and concerns over its pension fund deficit have distracted investors from the company’s strengths – notably the growth potential of its mobile business following the acquisition of EE and its consistent cash flow.
PLI’s new holding in Next also did not perform well, according to Mark, following a disappointing Christmas trading update. However, towards the end of the period, its share price rose as it narrowed its profit guidance range for 2017. Mark says that this underlines the recovery potential in the shares following their de-rating of the past year.
The share price of Circassia fell sharply on news that its cat allergy drug had failed to meet the primary end point of phase 3 trials. Mark comments that, while this was very disappointing and surprising news (he says that the drug had performed well in phase 2 trials) it is noteworthy that Circassia retains significant cash on its balance sheet and that, over the past year, the company has also made significant diversification into respiratory drugs, devices and technologies. Mark reports that confirming this, Circassia saw its share price rise in March as it confirmed a new strategic collaboration with AstraZeneca in combating respiratory disease.
Other domestically focused holdings to deliver negative share price performance included Derwent London, N. Brown, Game Digital, Secure Trust Bank and TalkTalk Telecom.
Portfolio activity
In terms of portfolio activity during the year, new investments were made in Aviva, Hadrians Wall, Next and Secure Trust Bank. The holdings in Reckitt Benckiser and Smith & Nephew were sold.
Outlook
In Mark’s view, the steady rise in the UK stock market over the last twelve months has created an environment where the valuation and, in consequence, the index level are vulnerable to disappointment; he says that there is a sense of complacency in several areas. The main driver of improved earnings growth has been a combination of a recovery in commodity prices and a collapse in sterling. Mark believes that, in the absence of a continuation in these trends the underlying earnings growth of the market remains lacklustre. He says that it is plausible to envisage an environment which is more positive towards sterling, given the pessimism the market has priced in over the last 12 months, and that factor alone may be sufficient to restrain further gains, particularly in the FTSE 100 index. In addition, the change in the US interest rate environment may act as a headwind for the time being, although given the continued low inflation outlook it is unlikely that the US Federal Reserve will raise rates in big steps or more than four times this year.
According to Mark, the overall political backdrop remains the other major influence on equity markets. There are elections in many major economies, including the UK again, accompanied by a heightened threat from geopolitics which may yet prove disruptive for business confidence. For the foreseeable future it appears likely that the economic backdrop will remain more predictable than the political one.
In conclusion, Mark expects that the stock market may struggle to make significant overall progress but he says that the portfolio is well positioned, invested in a diversified range of companies which have the scope to increase in value, driven either by sustainable dividend growth or from companies that can improve or transform their financial prospects regardless of the wider economic environment. In addition, he thinks that a number of holdings that have temporarily fallen out of favour have significant recovery potential.