The Big Interview: Mark Barnett

Mark Barnett manages the £579m Perpetual Income & Growth Investment Trust (PIGIT) and is part of the highly regarded Invesco Perpetual UK equities team. Here, he outlines his views on where we are in the cycle, the probability of a double-dip recession and the prospect for government-related companies in the face of public sector cuts

Your fund management group is well known for its focus on what is called an equity income strategy, which you operate within your own funds, but with a growth bias – a reliable or quality growth strategy. It has not been an easy year for this strategy, with classic defensive stocks underperforming the market. There is some evidence markets are changing their tune though. Do you think we are at the beginning, middle or end of a retreat to safety?

We are in my view hardly even starting. The market’s willingness to buy cyclicality, to buy into cyclical recovery has over the last year propelled the index very sharply up from its lows. There has been a substantial divergence of performance across the index which has resulted in cyclical companies trading on high multiples, relative to reliable growth stocks, rather than just defensives.

The kinds of companies I think have been left behind are what I would term our reliable growth stocks. These are companies that generally over long periods of time have upgraded rather than downgraded earnings and over long periods of time – 10 to 20 years – have exhibited very low volatility of earnings growth.

So their earnings do fall, but the amplitude of the ups and downs is very much shallower than in a cyclical company. These kinds of companies have been left behind, no doubt about it

Give me an example either by company or sector.

Pharmaceuticals, utilities and we could talk about consumer staples and tobacco. Also companies like Capita and other support services businesses. What you found is that in the markets these companies are massively left behind. Now that has started to change, and obviously the events running through the Greek sovereign debt crises have prompted people to think again.

The Greek problems have highlighted the market was probably too complacent about the strength and acceleration of the economic recovery and there are big issues which still need to be confronted. And these issues are not going to go away.

Many economists and analysts beg to differ with your caution – they suggest there will be a strong cyclical recovery in the USA.

The US is seeing a better recovery. Whether that is strong, I think the jury’s out, it is too early to say.

The background to the recovery in the US and also in the UK has been a massive stimulus, which continues in America – interest rates are still at zero, and there are still incentives around.

It is too early to say whether the recovery is stronger than anywhere else or if it is sustainable.
I am not sure and to a certain extent the markets got carried away in the belief we are experiencing an early-90s normal-style recovery. Were it not for the stimulus, we would not have a recovery. It would have been surprising if we did not have a recovery given what they have thrown at it.

This is not a normal recovery where interest rates were reduced in order to stimulate credit demand and growth and that started off the next up cycle – this cannot be a normal recovery.

Does that mean when the stimulus is withdrawn at some point we will lapse back into a double-dip?

There is a risk that happens, but I do not think it is a very high one. But by the same token, I do not believe the recovery is accelerating. I think the recovery will be muted and for that reason, the stimulus might carry on for longer.

When do you think the penny is going to drop and investors will start moving back into the reliable growth stocks you champion?

The valuation differential now is very big between reliable growth and the rest. In many respects, it is as big as it has been in the last 20 years, which is my life in the stock market.

Also, the extent to which these companies continue to get upgraded, albeit sometimes modestly, and yet do not get re-rated by the market cannot carry on. That situation cannot persist forever.

So my belief is I am worried and continue to be worried about aspects of the economic recovery. We cannot take it for granted and I do not believe it is self-sustaining – there are headwinds around relating to economic growth. Having identified that as an overall macro picture, the kinds of companies I want to own are cheaper now than they have been relative to the market since the tech bubble.

How cheap are they using the P/E ratio?

5% to 10% over the long period. Over the last 20 years of looking at a basket of companies, which you would classify as reliable growth, they tend to trade at 10% to 30% premium to the market. There could be as much as a 5% to 20% uplift.

Will the market wake up to this opportunity this year?

Yes, things are changing and I believe value will out and it does not remain on the table forever.

Looking at individual holdings within your fund, what is the single biggest bet you have made? What best typifies your alpha?

My biggest overweight is Capita.

How does this compare with your other big holdings? You have some other big bets on the market, sectors such as tobacco and oil.

I do not hold any BP or Shell, and those are the biggest companies in the market. My biggest holdings happen to be tobacco and I hold non-UK tobacco as well. So two US tobacco companies, which are nothing to do with the index because they are not in it at all.

What about classic high dividend stocks – how do they fit within your portfolio? A lot of investors have traditionally held the big oil companies for this reason.

There might be a political overlay this year for BP with regard to what has happened in the Gulf of Mexico, but I think at this oil price the dividends will get paid. There will not be much growth and that is the reason why I did not hold them.

Essentially, you are interested in the quantum of the dividend growth as opposed to the headline yield rate.

It is the growth in the dividend payout along with the anticipated changes in that growth that drives the stock price, not the snapshot headline yield.

The likes of Vodaphone, BT, BAT, Glaxo, AstraZeneca and BAE are all yielding 4.5% to 6% and growing dividends, which is better than inflation. In many respects you are getting paid to wait for the market to realise the value is there, and I get a 6% yield just for owning it.

Do you think the UK markets are very cheap compared to the American and European markets?

No, I think it is probably fairly valued, there are pockets of overvaluation. Namely, chunks of the mid cap which have performed very well, industrial cyclicals primarily.

Mining would be the other area and I think there are pockets of undervaluation. I do not see the FTSE 100 falling down below 5,000 and collapsing. But on the other hand, I do not think we are going to go over 6,000 either.

Are we condemned to be range bound?

Yes, although I think there will be rotation. There is value in the telecoms, in pharma, in food retail, in tobacco and in utilities.

One key part of your outlook must be based on foreign currency, its impact on earnings flows and ultimately dividends. If sterling remains weak, that surely must be good news for earnings and thus for dividends in much of the internationally diversified FTSE 100?

The bulk of the companies I own have dollar-related revenues. I think the eurozone has issues, but so does the UK.

I am more comfortable owning dollar-related revenues than sterling at the moment and if I want to own sterling revenues it has got to be in companies that are much more secure.

I do not really want to own retail, house-builders or leisure. I am much more comfortable owning utilities, which obviously have an inflation link to their revenues, or Tesco, or outsourcing companies such as Capita

We have got a change of Government and you have a heavy exposure to Government-related companies. Do you think the new Government is good or bad news for companies like Capita?

Central Government needs to address the debt position, and obviously they are going to be pulling all sorts of levers they were not prepared to talk about during the campaign. Included in which will be outsourcing processes, which have started in some government departments – the MOD, for instance.

Capita will be a beneficiary of that as will Serco. Babcocks in that as well and BAE interestingly is also a support services company.

So, from where I sit, the Government does not have a choice. Capita has also made substantial inroads into local government as well as in the private sector – in areas like financial services and insurance services, where it is very strong.

But the big concern is the Government will have to cut spending and increase taxes. Surely that means there is a very real possibility of a double-dip recession in the UK prompted by Government reaction?

There is a risk of one, I would not say it is substantial but there is a risk of one.

I am guessing the probability of a double dip is under 50%.

Under 50%, yes.

But I am also guessing you are suggesting it is not an outside bet at 10%.

I do not think it is a high probability.

But this fear of a double-dip recession is nevertheless real and forcing investors to notch down their equity exposure. But this move back from risk comes after a decade or two of poor returns from equities overall, compared to bonds at least. It is not a pretty picture in asset-allocation terms for equity investors. Equities were dumped over the last two or three years and the last 10 years with private investors rushing into the comparative ‘safety’ of bonds. It is not good news for equity managers, is it? Should we all be jumping into bonds?

Funnily enough, over the last 10 years with us you have not lost money in our equity funds, you have made a lot of money. You know, in some of our funds you have doubled your money in the last 10 years. The equity market does what it does and the last 10 years have been a bad period, but some of our funds have done very well.

Also, the measurement of the last 10 years begins at a period when the market was overvalued and has de-rated in the subsequent decade.

So you have seen a period of de-rating to a position where it is not overvalued now, and there are a large number of stocks that are cheap.

So the equity asset class as a starting point is quite an interesting one. The risk ultimately is we do get some unexpected inflation, which means the best place to be will be in equities.

Are you tempted by bonds?

If I was a neutral investor looking at bonds or equities from this point, given the credit risk, the cheapest way of playing risk is in the equity class compared to the bonds. They have performed well but you are getting no growth, but equity has a very good chance of growing and probably will.

Given this, would you be upping your exposure to equities now?

Yes, if I can give you 5% to start off with the dividend yield and then another 3% to 5% in capital – 10% is not a bad return.

Given this confidence in returns, would you be willing to increase your leverage in your investment trust?

Interest rates are 0%, or 0.5%, and inflation is somewhere between 3% and 4%, depending on which measure you use, and government bonds are risky and plentifully supplied. So actually, what return should we expect from the equity market against that backdrop? Well 8% to 10% a year is probably quite a good return. And if I can deliver at least half of that out of dividends, the bar has already been lowered – that is what is on offer at the moment in the market.

With that in mind, going back to my earlier question, would you increase your leverage if you had the opportunity?

Yes.

One last more medium- to long-term question vexing many investors at the moment: inflation versus deflation. Do you buy that deflationists argument?

Not entirely, but elements of it, yes. I mean the de-leveraging is definitely deflationary, but what is the Government about to do – put up taxes? That is not deflationary, it is inflationary.

So I do not believe we are heading into Japanese-style deflation. But there are elements of the Japanese scenario I think we are mirroring a little bit here in the UK.

Gross Assets - 537.0m

All as at 30th May 2010