Schroder UK Growth Fund (SDU) has released it annual results for the year ended 30 April 2017. During the period, the company provided an NAV total return of 17.5% and a share price total return of 13.9%, both underperforming its benchmark, the All-Share Index, which the company says provided a total return of 20.1%. The manager comments that the UK equity market performed strongly over the 12 months as the outlook for global economic growth improved and sterling fell.
Portfolio performance
The manager says that, over the last five years, investors have been conditioned to falling profits expectations and so have given reliable growth businesses ever higher ratings. It says that this reversed last summer with the expectation of significant profits growth in the short-term, partly because of weak sterling after the Brexit referendum but also reflecting the improvement in global growth. As a result, there was a rotation away from sectors with stable businesses (defensives) towards sectors that benefit more from rising growth (cyclicals), such as financials, resources and industrials.
The manager says that this divergence between cyclical and defensive sectors was matched, in a period of sharply falling sterling, by a divergence between businesses with international earnings and those more dependent on domestic sources. It says that this can all be seen in the performance of commodity sectors (Mining +46%, Oil & Gas +23%) as well as Construction (+39%), Industrial Engineering (+59%) and Banks (+33.5%). Conversely, domestic companies performed relatively poorly, e.g. Food Retail (+9.9%) and General Retail (+0.2%). In addition, more defensive sectors underperformed, e.g. Electricity (-2.0%), Gas & Water (+3.8%) and Healthcare & Pharmaceuticals (+14.0%).
The manager reports that the net effect on the portfolio, relative to the index, came through more at a stock than a sector level. As an example, the underweight position in HSBC hurt performance, with the bank a beneficiary of many of the trends above, particularly the improving outlook for emerging market growth and the translation of its international earnings into sterling. The portfolio was also impacted by its underweight to mining shares, after economic stimulus by the Chinese authorities coupled with rationalisation of supply boosted commodity prices. Finally, the portfolio was impacted by profit warnings in two stocks where there had been accounting misstatements, IT company Redcentric and BT.
The manager says that, on the positive side, the portfolio benefited from holding Cobham, Bae Systems and Chemring in an Aerospace & Defence sector that looked cheap on cyclically-adjusted valuations. Indivior, a pharma company treating opioid addiction, was the top contributor, after a court upheld several of its patents. Other positive contributors included financial infrastructure business NEX Group (formerly ICAP) and transport operator FirstGroup.
Portfolio activity
The company says that market movements, over the last 12 months, lead to the manager finding an increasing number of value opportunities among domestic cyclicals, as concerns over the outlook for disposable income have been discounted in valuations. As examples, the company initiated a position in retailers J Sainsbury, Marks & Spencer, Halfords, and gaming group Ladbrokes Coral. In the financials sector, the company increased exposure to Standard Chartered and initiated a holding in HSBC.
The manager sold out of holdings that have performed well where it felt the value opportunity had played out, such as business information group, RELX, pest-control specialist, Rentokil Initial, accountancy software company Sage, cruise company Carnival and tobacco company Imperial Brands.
Outlook
The manager says that, while last year saw strong rotation towards more cyclical shares, there are signs that US growth momentum is beginning to roll over and that Chinese authorities have started to tighten policy. It says that valuations for the market in aggregate look high while at the same time, heightened uncertainty is likely following the general election and as the Brexit negotiations start. These factors, the manager says, makes it reluctant to use the borrowing facility at the moment.
However, the manager says that the portfolio is full of stocks representing good cyclically-adjusted value, a measure that has worked well for its investment approach in the past. The manager says that it is finding this value today in four areas: domestic stocks (for example Tesco, Ladbrokes Coral); financials (eg. Standard Chartered, Lloyds) ; recovery stocks (eg Balfour Beatty); and certain commodity sectors (eg Royal Dutch Shell). The manager believes that these stocks provide a sound foundation for the future of the portfolio, notwithstanding the political and economic challenges that are likely to continue to impact markets.
Schroder UK Growth underperforms strongly rising market : SDU