Unpicking portfolio positioning

In order to achieve the blend of income and growth shareholders look for, we invest across the defensive and cyclical spectrum of the market. The chart provides a helpful overview of the areas where we are leaning the portfolio. Presently, much of it is concentrated in high growth cyclicals and low growth defensives, with the former helping to power the trust’s growth engine and the latter a more fertile ground for income. 

Within the low growth defensive side of the market, we’ve concentrated our positioning in high quality companies that are asset light and have the ability to grow without deploying significant capital, which they can instead return to shareholders as dividends. One such company is CME Group, which operates financial derivative exchanges. The stock trades on attractive free cash flow yields and would be a beneficiary in the event of a market downturn, where volatility picks up and transactions volumes increase.

Also in the same space, we are overweight defensive consumer stocks. These companies have historically struggled with cost inflation eating into margins, but we now believe this trend has abated. Valuations are now compelling and we took the opportunity to increase exposure to quality companies at attractive prices.

Our biggest source of excitement in the high growth space is in semiconductors. After a recent correction, we expect demand for semiconductors to increase, driven by the proliferation of AI. Many of the semiconductor companies we invest operate as a monopoly or in a duopoly, which means that they can exercise their pricing power and maintain margins as volumes increase. At the same time, the capital intensity of these businesses are falling, suggesting the potential for better free cash flow generation.

Covid related margin pressure

The main area that the portfolio is underweight is in low growth cyclicals. This is broadly due to our view that the abnormal supply and demand dynamics during the Covid pandemic are still having an effect and once they filter out, some companies’ margins will be vulnerable.

During the height of the pandemic, stimulus packages amounted to around 25% of global GDP, helping to prop up demand at a time when supply was constrained. As a result, company margins leapt higher and are now at levels that we think are unsustainable once pandemic era dynamics play out. In fact, margins have already started to decline but despite this, consensus forecasts for the future remain optimistic. Too optimistic in our view. 

One sector that we think demonstrates this theme quite well is the autos sector. During the pandemic, demand for new and second hand vehicles sky rocketed while supply chain constraints added to price increases. As a result, profit margins for auto manufacturers hit levels we’ve never seen before. Since then, supply issues have eased, inventories are being built up again and the high demand of the pandemic is unlikely to remain constant, all pointing to margin deterioration.

This isn’t to say we are not finding some companies in the low growth cyclical space that we think have a strong investment case. We think the aerospace and defence sector exhibits both cyclical and structural tailwinds and our position in Paris-based Safran is reflective of this. In consumer cyclicals, we like fellow French company LVMH, which we think displays really attractive fundamentals.

Packaging stock insights into a portfolio

Our stock selection is informed by our tried and tested investment process, based on rigorous fundamental research. We invest in companies where we think we have an information advantage over the market, and where the stock exhibits valuation upside and high quality. Historically, our stock selection has added significantly to excess returns, and while there is no guarantee that this will continue, we are confident in the positioning of the portfolio against the current market backdrop.