Murray Income (MUT) is in the middle of a strategic review that began in July and the board says should come to a conclusion in the fourth quarter. It has assets of about £925m, so that makes it a decent prize. I would expect that it has been inundated with all sorts of proposals.
The spark for this feeding frenzy was the trust’s disappointing returns to the end of June that were the subject of annual results published last Friday 12 September. I wrote a Citywire article about the review early in July, in which I wondered whether there was a danger of abandoning Murray Income’s bias towards quality stocks at or close to the bottom of the cycle for this investment approach.
What is quality?
We interviewed Charles Luke, MUT’s manager, in December 2023. The evidence of the trust’s struggle to beat the UK market was already there as it was lagging the All-Share over three years and had suffered a material widening of its discount. Luke gave a thorough description of his quality investing approach in that interview. He has also examined it in some detail in MUT’s annual report.
The main things that he looks for are: a sustainable competitive advantage, a high return on capital, strong financial characteristics (cashflow and balance sheet), and trustworthy management.
“high-quality stocks have significantly higher excess returns than junk stocks”
In his report, Charles cites some academic studies that support the case for quality investing. The first of these was “Quality Minus Junk” published by Clifford S Asness, Andrea Frazzini, and Lasse Heje Pedersen in November 2018. Like most of these studies, it bases its conclusions on the returns from US stocks, in this case between 1957 and 2016, but it also augmented this by looking at returns from stocks in other developed market between 1989 and 2016. The study concluded that high-quality stocks have significantly higher excess returns than junk stocks.
They constructed portfolios that were long the top 30% of stocks ranked by quality and short the bottom 30%. In 23 of the 24 countries that they analysed, such a portfolio would have delivered positive returns, performing particularly well in market downturns. The study also concluded that there are times when quality stocks are expensive and these are not great times to be investing in quality. This may feel obvious, but it never hurts to have empirical evidence to back up your assumptions.
Other quality-style investors lagging
When we look around, other UK-focused investors that put an emphasis on the quality of their investments are also struggling. Notably, this includes Nick Train at Finsbury Growth and Income (FGT) and Luke’s colleagues Ben Ritchie and Rebecca Maclean on Dunedin Income Growth (DIG) whose five-year performances are even worse than MUT’s. It also includes Charles Montanaro at Montanaro UK Smaller Companies (MTU) and Dan Whitestone on BlackRock Throgmorton (THRG), whose difficulties have been compounded by the recent poor returns of UK smaller companies. All of these managers are further impeded by the general underperformance of UK equities relative to international peers.
This all sounds rather depressing, but it is also puzzling. In retrospect, it does seem reasonable that faced with the uncertainty of COVID, investors flocked to quality investments and some of these stocks ended up being overvalued. But why should the consequences of this still be affecting quality stocks five years later?
Is it because investors are still selling UK?
A recent conversation with Matt Cable, manager of Rights and Issues (RIII), threw some light on this. He reckons that most active fund managers in the UK have a preference for higher quality stocks. As investors have pulled money out of UK equities, these quality stocks are being sold to fund redemptions and buybacks. This in turn leads to further underperformance and more selling pressure. However, he is convinced that the pendulum has swung too far. The rising tide of bids for UK companies maybe evidence of this. So, it is possible that the people abandoning quality-biased investment approaches will come to regret their actions.
Value and quality are not mutually exclusive
I still think it is inevitable that MUT shareholders will be offered the chance to roll into an investment company with a much better five-year track record. Top of the UK Equity Income sector currently, and my pick of potential acquirers, is Temple Bar (TMPL). It is nominated for best UK investment company in our awards. Fortunately, while quality may be overdue a renaissance, it also feels to me as though TMPL’s value style can continue to work in its favour for some time yet. The two are not mutually exclusive.
