Q&A: Schroders Income Fund

Stock-picking forms the foundation of our investing, and we are committed and disciplined value investors. We believe that stock markets are inefficient. The major assumption underlying much of modern day economic theory, including the principal theory of efficient markets, is that people are rational. In reality, people experience emotions and inherent biases which cause irrational decisions to be made. In investment markets, this can cause company share prices to deviate from the underlying company fundamentals and this provides an opportunity for investors willing to stand back from the market noise and take a long-term perspective.

The stock market has a tendency to make two key errors. Firstly, it tends to extrapolate short-term trends, both good and bad, ignoring the potential for mean reversion in profits. History has shown this mean reversion to be a long-term feature of most companies’ earnings. Secondly, the stock market accords companies a valuation that reflects their short-term profit prospects and not their long-term mean reversion potential. This creates a significant opportunity for value investors to buy those areas of the market where valuations are at their lowest, but where companies have the ability to improve profits, at a time when others are selling for irrational reasons. Over 100 years of equity market data shows that purchasing a stock at a low valuation in relation to its asset value or earnings power has led to superior long-term returns.

Q.2. What are your views on Brexit and its implications to your fund and beyond that the UK investment landscape?

We do not take a view on macroeconomic trends as we believe identifying mis-priced individual securities is a more repeatable skill than that required to forecast the complex interrelated variables in a macro based strategy.

Q.3. How far down the market cap do you go with in the fund?

The fund can invest in UK companies of any market capitalisation. Currently the fund has 87% invested in companies with a marker cap over 3billion. The fund can also invest overseas where there are attractive opportunities, typically in larger companies with global reach.

Q.4. What sectors do your currently follow and why?

The main sectors in the fund are financials, consumer services and basic materials which make up over 60% of the fund’s asset allocation.  The fund is noticeably overweight in financials compared to the benchmark and particular overweight in the UK banking sector, this is because we believe that the majority of investors believe the prospects of the UK banking sector as worse than they are.

Earlier this year – after the ‘big four’ of Barclays, HSBC, Lloyds and RBS published their full-year results for 2016 – we carried out an extensive reappraisal of the UK banking sector. Total assets and risk-weighted assets for the four actually peaked at £6.6 trillion and £2.1 trillion respectively; both figures are now broadly in line with where they were in 2007. Much more importantly, however, the UK’s big four banks have significantly less leverage than they did just before the financial crisis, from a ratio of 46x in 2007 to 18x now. Therefore the banks are less vulnerable to shocks such as the financial crisis.

In addition, their tangible equity – which is another measure of a bank’s ability to deal with financial losses – has more than doubled. Yet, the four banks’ combined market capitalisation is close to what it was in 2007. In other words, Barclays, HSBC, Lloyds and RBS have all been through a period of significant ‘de-risking’ – now holding a lot more equity relative to the liabilities on their balance sheets and the size of their businesses – and yet the market is giving them absolutely no credit for that whatsoever. With this state of affairs largely unchanged from when we reappraised the sector back in March, we remain as comfortable with our banking exposure now as we did then. We believe investors were, in each instance, so concerned by the sectors’ respective negatives they had become blind to how they in fact boasted well-run businesses with attractive dynamics and sensible amounts of debt.

The fund is also noticeably underweight compared to the benchmark in consumer goods. This is because the ever-higher prices the wider market has been willing to pay for the perceived safety of many traditionally defensive assets – for example, food, beverage and , tobacco stocks – but this means when any bad news comes, it is taken very badly indeed.  The reality is many are buying these stocks not for their underlying quality but for the simple reason they are going up in price.

In essence, they are not buying what they think they are buying – high-quality businesses with stable earnings – but very sensitive and increasingly expensive assets.

For further information please head to the Value Perspective. The Value Perspective is an extensive resource for providing information on ‘value investing’ in equities. http://www.schroders.com/en/uk/the-value-perspective/

http://www.schroders.com/en/uk/the-value-perspective/blog/all-blogs/three-charts-on-why-uk-banks-are-far-stronger-than-pre-northern-rock/

http://www.schroders.com/en/uk/the-value-perspective/blog/all-blogs/how-tobacco-stocks-could-now-be-damaging-to-your-wealth/