Focus on US value trumps trade concerns

By Fran Radano, Senior Investment Manager, The North American Income Trust plc

  • Steady global growth ahead if trade negotiations produce a positive settlement.
  • Bank valuations remain too low following de-risking, low defaults and good quality loan books.
  • Trust is well diversified, with high quality, cash generative companies across nearly all sectors.

The ongoing China-US trade negotiations represent a highly unpredictable situation, with the threat of tariff increases hanging over the global economy. Until now China has been regarded in economic terms as an emerging market country, with accordingly very low tariffs, but it is no longer an emerging market. The core issue is essentially structural, with the US primarily seeking a more level playing field. Considered in those terms, President Trump’s demands aren’t entirely outrageous, though his communication style can be ineffective.

We are optimistic that the talks can eventually produce a reasonable settlement. China knows only too well that the global supply chain continues to diversify and it understands that the longer the trade negotiations go on, the more companies will choose to set up their operations in other low cost areas.

The situation is one that can be resolved in a way that allows China to be a strong partner, while also providing the US with the more level playing field that it wants. The hope is that sensible minds will prevail – provided we arrive at some form of solution and a reasonably fair set of agreements, global growth will continue. 

But even if there is no such satisfactory outcome, we know our companies well enough to understand the likely impact. The North American Income Trust remains well diversified and we are not especially overweight in any particular sector. We have also been able to build up three quarters of a year worth of reserves.

The Trust consists largely of US companies and thus converts US dollar dividends to Sterling, which does creates the potential for a currency impact if Sterling were to snap back strongly in the event of any Brexit agreement. But we hold good reserves, and by shifting dividend income to Sterling as and when it comes in, we have been able to mitigate any cliff-edge risk. 

With a concentrated portfolio of approximately 40 stocks, typically but not exclusively drawn from the S&P 500, we don’t have to own anything we don’t like. For example, while there have always been some utilities stocks in the portfolio, the first half of the year saw us exit our last holding in the sector, CMS Energy. There is a value rationale behind this as utilities is a classic bond proxy that investors have tended to migrate towards in a low inflation, low interest rate environment. This drives up utility stock prices with the result that the risk-reward characteristics of utilities now look unfavourable to us and their dividend yields are less compelling.

Today we see more value in financials, and the banks in particular. They have not been great performers over the past year and the banks that have de-risked since the financial crisis arguably remain over-capitalised. But defaults are at the low end of historic ranges and we don’t see any reason for those levels to go back towards their peak. Loan growth hasn’t been high, but the loan books are reasonably healthy and good quality.

At around 10 times forward earnings we believe banks are valued too low, especially when we look at metrics, balance sheets and de-risking activities. When the general market is trading at valuations around 17 times analysts’ estimates of next year’s profits, we see no reason why banks can’t be 12 times, 13 times or even 14 times earnings estimates. 

We took a position in Citigroup for the first time in early 2019, seeing it as a classic value laggard. It was trading below book value even though its management had done a good job of shedding many low quality parts of the business and beefing up the core operations. Citigroup is a classic value trade where the fundamentals are improving not just because of the macro picture, but also because of its own strategy. 

By contrast, we avoid the FANGs (Facebook, Amazon, Netflix and Google) for the simple reason that they don’t pay dividends. We like the discipline that dividends places on companies. The stocks we invest in will usually pay above-market dividends (around 2.5% to 4%) and also invest back into the business. 

We sold out of Microsoft, not because it wasn’t a great business model with a great balance sheet and great management, but because we decided that it had already done what we expected of it. With the stock now rated more accurately, the dividend yield has fallen and it’s at the high end of the valuation range which means it no longer fits our remit.

The market has a tendency to chase revenue growth and overlook those companies trading at more attractive valuations. But our investors understand that we don’t buy companies because of what does or does not happen in trade agreements. Each trade we carry out is well measured – good companies in good positions at fair prices are the stocks that, over time, tend to work. 

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