Mark Martin, Manager of the Neptune UK Mid Cap Fund, and Assistant Manager Holly Cassell explain how they look past short-term volatility to focus on maintaining a strong long-term performance record.
Long-term gains often require short-term pain With market valuations approaching historical highs and pockets of value hard to come by, it is our view that stock selection is of very high importance at this time, particularly given the level of uncertainty in the UK outlook. In fact, as long-term investors, we are particularly excited about the potential to add value while many around us are panicked by short-term fluctuations in the market. Given our multi-year investment horizon, we invest in companies that we believe are well-positioned for future growth and are able to look through short-term volatility to the extent that it does not affect our long-term investment thesis.
In particular, we have a preference for companies that are investing in the future of their businesses through temporary increases in capital expenditure and spending on research and development. While this increased investment will inevitably detract from free cash flow and returns in the short term, it should enable firms to generate higher forward returns than could be expected from companies attempting to appease income-hungry shareholders in the short term. These kinds of companies often screen badly and are overlooked by investors as a result; therefore they are often where we see the greatest potential for positive multi-year returns.
Increased investment in new plant or M&A often leads to earnings downgrades among the sell-side analyst community due to their shorter-term horizons; however, our focus continues to be on generating positive risk-adjusted returns over the course of the cycle. Indeed, companies that have suffered short-term share price weakness due to long-term capital expenditure (capex) programmes have been central to the Fund's strong long-term performance record. Notable examples of stocks where we believe recent underperformance will give way to strong returns include:
- Mears Group (social housing and domiciliary care)
In the aftermath of the Brexit decision, we saw widespread investor aversion to domestic UK companies. As 100% of Mears Group's revenues are generated in the UK, the stock screened poorly and sold off sharply alongside many of the domestic cyclicals. We believe the market failed to take into account the company's excellent management team, long-term contracts - which provide highly visible pipeline revenues - and its ability to take advantage of increased outsourcing of services by local councils.
In addition, Mears bought the loss-making Care UK business last year, which we believe was a strategically sound acquisition. Despite Mears' management team's good track record in turning around acquired businesses, the acquisition resulted in earnings downgrades in the short term. However, the Care UK business is now approaching profitability ahead of schedule, driving upwards earnings revisions and likely improvements in the share price in due course.
- Devro (manufacturer of sausage casings)
Devro's long-term growth prospects are underpinned by structural increases in emerging market protein demand. While there has been increased competition at the lower end of the Chinese market in particular, Devro's products are of higher quality. Given the traceability of its products and high food safety standards, its reputation has been boosted relative to peers by recent industry supply chain scandals.
- Ultra Electronics (defence technology)
Defence is a sub-sector in which we are currently finding plenty of exciting opportunities. The USA remains the biggest export market for defence companies, which therefore benefit from dollar strength. Furthermore, US defence budgets are on the rise, and we expect this will continue regardless of who is the next president. We also believe the industry is ripe for M&A, with restrictions on further industry consolidation within the US.
We believe that Ultra's weak performance since Brexit is due to indiscriminate selling of FTSE 250 stocks by UK All Companies managers, regardless of company fundamentals. Compared to BAE Systems (a FTSE 100 company with similar end markets), Ultra Electronics has a higher proportion of dollar revenues and smaller pension deficit, but has failed to re-rate in line with its large cap peer. From the referendum to the end of August, BAE's share price rose by 7%, while Ultra's fell by 6%. We have seen early signs of the gap between the two starting to narrow in recent weeks.
All three of these stocks have weighed on performance in the short term but remain high conviction picks within the Fund, which is - broadly speaking - currently underweight UK-focused domestic cyclicals, instead favouring defensive UK names and those with significant international earnings.
A proven and disciplined investment process
We believe our disciplined investment strategy is a key driver of the Neptune UK Mid Cap Fund's ability to deliver strong returns across the cycle on a risk-adjusted basis. This strategy is structured around three silos in order to minimise cross-correlations between our holdings. The three silo structure - consisting of corporate turnarounds, structural growth and economic recovery - has been in place since inception and ongoing analysis indicates that the process' diversifying effect continues to reduce volatility within the Fund. By having at least 20% of the portfolio invested in each of these three silos, the Fund seeks to limit its downside risk. Although in a rapidly rising market this may mean the portfolio modestly underperforms in relative terms, we believe it should allow the Fund to generate periods of outperformance when markets are flat, falling or exhibiting volatility and, indeed, history has demonstrated this to have been the case. We are excited about prospects for the Fund and are confident that our disciplined and proven investment process will continue to deliver long-term outperformance. Neptune UK Mid Cap performance.
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Investment risks
Neptune funds may have a high historic volatility rating and past performance is not a guide for future performance. The value of an investment and any income from it can fall as well as rise and you may not get back the amount originally invested. A majority of the investments made by the Fund may be in securities of small and medium sized companies. Such securities may involve a higher degree of risk than would be the case for securities of larger companies. Neptune funds are not tied to replicating a benchmark and holdings can therefore vary from those in the index quoted. For this reason, the comparison index should be used for reference only. There is no assurance that the investment objective of the Fund will be achieved. References to specific securities are for illustration purposes only and should not be taken as a solicitation to buy or sell these securities. Please remember that forecasts are not a reliable indicator of future performance. These are Neptune's views and as such this document is deemed to be impartial research. Some information and statistical data herein has been obtained from sources we believe to be reliable but in no way are warranted by us as to their accuracy or completeness. The content of this article is formed from Neptune's views and we do not undertake to advise you as to any change of our views. Neptune does not give investment advice and only provides information on Neptune products. Please refer to the Prospectus for further details.
