Q. What is the underlying methodology used to pick stocks for inclusion in the fund? The aim of the investment process is to find companies whose outlook or growth prospects are not reflected in their valuations. To identify these companies we combine top-down and bottom-up research. These are then subjected to detailed fundamental analysis and valuation. The output from this analysis is then used to construct and review portfolios with the aim of maximising exposure to the most attractively valued ideas within the risk parameters of each individual portfolio. Our research is structured to give us a detailed understanding of a company’s key historical and future business drivers, such as demand for its products, pricing power, market share trends, cash flow and management strategy. This enables us to form an opinion on a company’s competitive position, its strategic advantages/ disadvantages and the quality of its management. As part of the investment process, the UK Equities team places significant emphasis on meeting regularly with company management. From such meetings, we believe: • We can gain an improved understanding of the near- and longer-term prospects of a company and the quality of its management. • They give us a forum to challenge their assumptions and predictions in person as well as ensuring that management understands our priorities as a shareholder. • They provide us with valuable information regarding the state of the broader economy and the businesses of a company’s suppliers, customers and competitors. This analysis is then considered in conjunction with a stock’s current and prospective valuation, enabling us to determine whether or not the stock is attractively valued. • They enable us to determine where there are sizable differences between consensus expectations and what the company expects to realistically achieve. In total, the team has contact with around 600 companies a year. Approximately 400 of these meetings will be on-site, with the remainder split between conference calls and in-house meetings. This information is then considered in respect of a stock’s current and prospective valuation, from which it can be determined whether the stock is attractively valued or not. Valuation When valuing a company we use the valuation technique that we believe most appropriate for the individual stock or the sector that it is in. These may include: • Earnings growth/momentum • PE • P/BV versus ROE • Dividend yield • CFROI • ROIC/WACC • Enterprise value/capital employed • EV/EBITDA • Cash flow/free cash flow • Sum of parts Q. How much value do you think is still on offer within the defensives space? Our view is that there is significant value on offer within the defensives space at present – although certain defensive stocks may currently look expensive, there are others that are very attractively valued. Q.What do you think will be the main challenges to UK Equity performance over the coming twelve months? The UK stock market, which has performed strongly over the past year, seems to us to be overly complacent about many things at present, not least the implications of the US fiscal cliff. Even if a deal is reached by Congress, we believe it is likely to impact negatively on US economic growth next year. In the Eurozone, while further policy initiatives by the European Central Bank, including the announcement of Outright Monetary Transactions, have reduced the immediate threat of countries exiting the euro area, the fragmentation of euro-area credit flows and economic headwinds have persisted. Economic growth in the Eurozone will necessarily remain weak we believe as the region embarks on the necessary process of deleveraging. Back in the UK, where de-leveraging is further under way, the resultant weak credit growth from banks is acting as an impediment to economic growth. While the risk of a Eurozone area default – with potentially very negative consequences for equity markets, has now reduced, we do anticipate that the above pressures on economic growth will result in further downgrades to company profit forecasts. As a result we expect that the share prices of the more cyclical companies could come under pressure. By contrast, we expect better share price performance from other more defensive companies, which are both more attractively valued and look better placed to cope with this pressure on forecasts. Q. What industry sectors are you currently favouring and why? We aim to invest in companies which we believe will be able to deliver consistent returns to shareholders despite a challenging economic environment. The companies should have a robust business model with strong cash flows, which they utilise to maximise returns to shareholders. Valuation is also key – we are not prepared to pay any price for these characteristics. We find such companies across a spread of sectors, but most notably in the pharmaceutical and tobacco sectors. The Invesco Perpetual High Income fund has over 30% of its portfolio invested in the pharmaceutical sector. Our conviction that this sector should deliver superior long term returns to shareholders is predicated on both the low valuations it currently trades on and a belief that the stock market is ignoring the companies’ ability to discover new drugs. We expect the companies’ recent poor record of drug discovery to change as their focus moves to more targeted drugs and innovative medicines, while there is exciting potential for growth in demand for drugs from emerging markets. In the meantime, and while they are going through this period of change, the companies are able to deliver strong cash flow and attractive returns to shareholders. The fund holds a broad spread of major Multinational companies within the sector, including two Swiss companies and one French company. The other sector where the fund is heavily overweight is tobacco. Tobacco companies remain highly profitable, cash generative and reliable providers of earnings and dividend growth. Valuations remain attractive, in our view, and do not fully reflect the quality, dependable characteristics that the likes of BAT, Imperial Tobacco and Reynolds American can bring to our portfolio. Q. The fund has outperformed the IMA UK Equity Income sector average over the past 5 years. What particular strategies do you feel have driven this out performance? The past 5 years have witnessed some extreme stock market volatility – the period covers both the financial crisis of 2008, which resulted in a sharp fall in share prices, and the subsequent very strong stock market rally on the back of monetary stimulus around the world. Over such a volatile period for the stock market, the fund’s performance benefited from its focus on companies with strong cash flow and able to deliver solid positive returns to shareholders, irrespective of the global environment. The main contributor to the fund’s rise over the period has been its holdings in the tobacco sector, while the pharmaceutical sector has also delivered a strong positive contribution. The fund had a zero holding in the banks sector over the period which also boosted performance on an attribution basis.
Fund Manager Q&A: Invesco Perpetual High Income
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