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Peter Elston’s Investment Letter – Issue 15: July 2016

18 July 2016

Recent fund performance

Since the referendum, our funds have slipped down the peer group rankings. This does not mean that their absolute performance has been particularly poor, just that the funds have underperformed their respective peer groups in recent weeks. While many will understand that poor short-term performance relative to peers – as well as in absolute terms – may happen from time to time, there may be others who are not so comfortable. The following will I hope provide reassurance.

Our funds are diversified in that they are spread across equities, bonds, and specialist assets. However, we are value investors and so are trying to capture the medium- to long-term price appreciation of financial assets that results from their value being under-appreciated. This is why we have a mid-cap focus in the UK – investors tend not to fully understand the scope for smaller companies to grow, so their share prices as a group tend to perform better.

As value investors we are also seeking to avoid financial assets whose value we think is being over-appreciated. This is why we do not hold developed world government bonds, which even before recent events were expensive – buy the 30-year inflation Gilt today and hold it to maturity and you are certain to lose a third of your real capital at today’s rates.

While we continue to have absolute confidence in our positions with respect to mid-caps focus and government bonds, both have hurt our peer-relative performance over the last 2-3 weeks. It should also be noted that we have other positions that have performed well or held up over the same period.

Many of our competitor funds own expensive Gilts or US Treasuries and avoid under-appreciated smaller companies. Such positioning will naturally – and indeed did – aid short-term performance but it will also very likely lower their longer-term returns. We think it is longer-term performance that is more important. In fact, given increasing longevity, paucity of value in bond markets, as well as low growth generally, we think it is more important than ever to focus on longer-term performance. The harsh reality of this however means having to accept the odd period of poor short-term performance, whether in absolute terms or relative to peers.

Our mid cap focus in the UK has been the major cause of the recent poor short-term fund performance in relation to our respective peer groups. However, we are very careful about what we buy, placing great importance on balance sheet strength and profitability. This we believe will help to produce good performance over time in relation to both mid-cap and large-cap indices and thus counter the impact of periods such as the last few weeks when mid-caps fell off sharply. Furthermore, we don’t own too many mid-caps, so we know them extremely well. Here are a couple of examples.

Kier Group is a conservatively managed vertically integrated construction and services company. Despite the fact that 85% of revenues in its two largest divisions are already covered by existing orders out to June 2017, the shares have been weak and now yield 7%. The dividend is well covered by earnings and supported by a strong balance sheet. Recent acquisitions of May Gurney and Mouchel provide considerable scope for further expansion, as cross-group revenue synergies are explored. Meanwhile, the company should also benefit from rising infrastructure spend which has cross-political party support. Specifically, the Highways Agency’s £17bn ring-fenced budget for its Road Investment Strategy and the National Infrastructure Commission’s £100bn budget out to 2020 provide tailwinds.

Victrex manufactures polyether ether ketone (PEEK), a high performance polymer that possesses unique qualities, such as being ultra-lightweight, extremely strong, resistant to chemicals and extreme temperatures, and is also electrically conductive. The company has dominant market positions and is frequently finding new uses for PEEK, due to its constant drive for innovation and ongoing collaborative work with its customers. Over 90% of Victrex’s revenues are from outside the UK, therefore it is a big beneficiary of sterling weakness. The shares yield over 3% and the dividend has grown by over 13% p.a. over the last 10 years. The company has net cash on the balance sheet and has stated that it intends to return surplus cash back to shareholders by means of special dividends.

Elsewhere in the funds, while we have some currency-hedged overseas equities funds, most are unhedged so have performed well as a result of the weakness in the pound. As for our fixed income funds, their prices have generally remained stable, though they have not of course performed nearly as well as safe haven bonds.

Of interest we think is the performance of some of our specialist assets. As a reminder, these on the whole are investment trusts that invest in income generating assets such as aircraft, property, medical equipment, loans, mortgages, and infrastructure. Again, we are very careful what we buy and, because we don’t own too many of them, we monitor them closely. We are looking for income streams that are stable and index-linked. We are looking for decent yields. These attributes have served some of our specialist assets holdings particularly well in recent weeks. Here is one example.

Primary Health Properties is a REIT invested in predominantly UK based purpose built modern GP surgeries and medical centres. It has a very secure tenant (NHS plus ancillary services), a visible and growing income stream, and resides in a property sector that requires substantial increases in investment.  The attractions of such low volatility tangible value are thus clear. The investment pays us a fully covered and growing dividend yield of 4.6%. At the time of writing (5th July) the shares are trading where they were prior to the referendum vote and have displayed none of the stresses experienced elsewhere in the property sector.

To conclude, we continue to have complete confidence in our process and in the capacity of our funds to generate value over the longer term. We place a great deal of importance on the quality of businesses we own and making sure that third party managers we engage have a similar mindset.


Brexit

There is much that can be written about the referendum result. Indeed, much already has been. I shall try to keep this simple and focus on what, I believe, are the two key questions for our investors and ourselves. One, what were the prospects for the UK and global economy before the referendum? Two, what has changed since?

For the last few years, growth in the UK and globally has been OK but not great. My view was that things were likely to continue in this vein rather than growth recovering to pre-crisis levels or on the other hand it slipping into negative territory.

I had a number of reasons for believing the global economy would continue to grow. First, that is its tendency. Despite the tiny minority who would like to return the human race to the Stone Age, most of us conduct our daily lives in a constructive way, both providing as well as consuming products and services. Aggregate that at a systemic level and you have what is called growth. And it’s quite hard to stop that in its tracks because, well, it’s what we like to do.

Since we quite like being constructive, we tend to do it more and more until economies overheat and central banks feel the need to step in and end the party. Looking at inflation prior to last Thursday, it seemed clear that economies on the whole were far from overheating. Agreed, some were closer than others, but at a global level it was obvious that there was a still a chronic shortage of demand rather than an excess of it.

Former US Treasury Secretary Larry Summers has written about this “chronic” demand shortage. He refers to it as secular stagnation – a term coined by Alvin Hansen in 1938 to describe what he feared the US economy was experiencing in the aftermath of the Great Depression. In fact, I was going to write about Summers’ deliberations on the subject in detail in this investment letter. Alas, Brexit has rather overtaken events and that shall have to wait. Nevertheless, Summers’ key conclusion is that secular stagnation is real but that it can be countered with public investment in areas such as infrastructure. Since fiscal austerity has not generally resulted in a strong recovery in private sector confidence, he argues, it should be stopped. Furthermore, econometric models suggest, he says, that although government borrowing as a percentage of GDP would at first rise, over time it would fall as the multiplier boosted the denominator, GDP.

I have had increasing sympathy with this argument and as a result felt more optimistic about the prospects for the world economy. That said, it will likely be a while before key policymakers listen to Summers – and the many others who share his views – and consider his proposed solution.

In the meantime, I believed that ultra-loose monetary policy would prevent demand from falling off a cliff while workforce slack would prevent inflation from rising to uncomfortable levels.

My somewhat hopeful view was supported by generally positive leading indicators, yield curves that were steep rather than inverted, as well as the aforementioned low inflation and labour force slack.

Then on 23 June Britons voted to leave the EU. What has changed as a result?

The most obvious and incontrovertible thing that has changed is that the referendum is now behind rather than ahead of us. This matters because the UK and European markets had been weak over the preceding year or so, arguably because the referendum lay ahead and represented uncertainty (in the 12 months to May 2016, outflows from all IA sectors totalled £38 billion). True, there are now other uncertainties that have taken its place but at least they are not binary in the way markets hate.

Another equally incontrovertible fact is that the ‘leave’ camp won the referendum. The market’s violent reaction suggested this result was both unexpected and perceived as negative for the UK economy, though equities have since recovered. It seems the most likely outcome is that at some point the British government triggers Article 50 of the Lisbon Treaty, thereby setting in motion the process to leave the EU. But it is far from clear when – and perhaps even if – this will happen.

In the meantime, there is scope for all sorts of developments. One of these must be for Brits to ponder whether the UK should seek to remain in the single market. If yes, we would have to accept free movement of people as Norway and Switzerland have. If no, we would have to accept tariffs on trade in goods and services with the EU. New UK Prime Minister, Theresa May, has said, “It must be a priority to allow British companies to trade with the single market in goods and services — but also to regain more control of the numbers of people who come here from Europe.” This is all very well, but the EU has made it clear that the UK cannot have both.

The pound has fallen sharply. In some respects, this is a good thing as the UK’s current account deficit as a percentage of GDP had reached an unsustainable 7% 1 (see chart 1). That said, the initial effect of the pound’s weakness will be to widen the deficit even further as imports cost more and exports are worth less. Longer term, the fall in the currency will be stimulative, though how much spare capacity the UK economy has to absorb this stimulus is unclear. Although wage pressures remain relatively subdued, Bloomberg Intelligence’s estimate of the UK’s output gap suggests that much of the excess capacity that prevailed after the Great Financial Crisis has now been removed (see chart 2).

Chart 1: UK current account deficit as % GDP

Chart 1 - UK current account deficit as a % GDP

Chart 2: UK output gap (%)

Chart 2 - UK output gap %

Bond yields have fallen sharply. As of 4 July, the yield on the 10-year Gilt stood at 0.83% compared with 1.37% on the day of the referendum. Interestingly, this was not due to a fall in inflation expectations. Quite the opposite in fact – the inflation rate expectation embedded in 10 year yields actually rose following the referendum, from 2.31% to 2.34%. In other words, it was a fall in real yields rather than inflation expectations that drove the fall in nominal yields.

Putting this fall in real yields in a longer term context as well as in the context of equity market yields is particularly interesting (see chart 3). The yield of -1.503% on the 10-year inflation protected Gilt as of 4 July suggests that if you bought it and held it to maturity you would make a total real return of -14% (for the 30-year the number is -33%).

Chart 3: Long term yields

Chart 3 - Long term yields

Bank of England governor Mark Carney has hinted he’ll loosen monetary policy over the summer. Furthermore, former Chancellor, George Osborne, backtracked on his longer term budget targets. It is clear therefore that both the Bank of England and the Treasury expected the impact of Brexit on the UK economy to be negative, perhaps considerably so. At the same time, evidence of an immediate impact is sparse. As of 4 July there were only 22 items on the FT’s Brexit Business Impact Tracker, a log of the expected impact of Brexit through company announcements and similar. Given all the warnings from UK companies ahead of the vote, it is perhaps surprising there have not been more announcements of cuts of some sort.

Chart 4: Citi WGBI GBP hedged (inflation adjusted)

Chart 4 - Citi WGBI GBP hedged (inflation adjusted)

There are many other things that have changed since the referendum that I have not mentioned. However, the point of those that I have chosen to highlight is that it remains very unclear what the longer term economic impact will be of the vote to leave the EU.

What we do know is that developed market government bonds are even more expensive now than they were prior to the referendum (the chart above suggests that the great bond bull market is running out of steam but taking a long time to end!) We also know that equity market yields are generally well above long-term historic averages. Therefore, as far as the big asset allocation call between bonds and equities is concerned, this suggests pretty clearly that one should underweight the former and overweight the latter. We are thus sticking with our current positioning.


1  Average of Q4 2015 and Q1 2016


Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 1: Current fund tactical asset allocation (TAA) target weights (as of 30 June 2016, prior month’s targets in brackets)

Table 1 - Current fund tactical asset allocation target weights - 30 June 2016a

  • No asset allocation changes in June
  • SDGF: we switched Prudential into Legal & General, after material outperformance by the former
  • Ocean Dial Gateway to India exited, following strong performance and a preference going forward for regional, rather than country specific exposure within Asia
  • Thomas Cook was exited to fund a new investment in Essentra, a global manufacturer and distributor of small but essential components, e.g. plastic screw caps, as well as health and personal care packaging
  • SDIF: we introduced two new names: Essentra and Arrow Global
  • The relative strength of fixed interest assets enabled us to fund the equity purchases with reductions in our two Royal London fixed interest funds. These sales followed reductions earlier in the month in emerging market debt (Pictet and Templeton)
    Strong performance through the month enabled us to take some profits from specialist assets, thereby releasing capital for other areas of undervaluation
  • SIGT: Holding in BHP Billiton was sold due to uncertain outlook for commodity prices and following recent cut in dividend
  • A new holding namely Essentra was introduced to the portfolio with the company having seen a significant derating following a profit warning in early June
  • Asian equity holdings were reduced following strong performance over recent months – bringing overall exposure back towards target weightings
  • Several specialist asset holdings were top sliced to provide funding for UK equity purchases

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Important Information

Past performance is not a guide to future returns. The information in this document is as at 30.06.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested.
This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/118.

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Peter Elston’s thoughts on the Brexit vote – June 2016

24 June 2016

A comment on the Brexit decision

We wake up today to the extraordinary news that Britons have voted to leave the European Union. The immediate question is what the implications are for financial markets and for our funds.

First, although we did not discount the possibility of this outcome, nor did we think it the more likely. We believed that although the polls were close, undecided voters would tend to vote to remain. We were wrong.

Our funds are multi-asset funds so have some natural defensiveness built in via exposure to fixed income investments and what we call specialist assets, some of which are denominated in foreign currencies that will be rising today against a sharply falling pound. But within our multi asset framework we are still exposed to investments, principally equities, which will fall sharply today.

We have always communicated the message that we are long-term investors so our hope, and indeed our expectation, is that our investors will remain calm. As the saying goes, if you are going to panic, panic first. We certainly think it unwise to join any stampede and indeed at some point would like to take advantage of the lower prices.

Right now it is unclear how far and for how long markets will fall though it is quite possible that markets today will end the day well off their lows. Markets have a tendency to overreact. We will be watching very closely but remaining calm.

Further out, it will be the implications of voting to leave the EU for the UK economy that will continue to occupy our thoughts. It was patently clear from the debate that even those campaigning to leave the EU did not know precisely what a post-Brexit world would look like. The financial markets are sending a clear message today that it could well be bleak, though that is by no means a certainty. Indeed 52% of the electorate believes that the UK’s prospects are now brighter. They and their flag bearers should now be listened to.

 


Download this investment letter as a PDF


 

Important Information

The information in this document is as at 24.06.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Before investing in the CF Seneca Funds you should read the key investor information document (KIID) as it contains important information regarding the fund, including charges, tax and fund specific risk warnings and will form the basis of any investment.

The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the Fund (0845 608 1497). Seneca Investment Managers Limited, the Investment Manager of the Fund (0151 906 2450) is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/107

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Peter Elston’s Investment Letter – Issue 14: June 2016

21 June 2016

Active management and the problem with “passive”

My attention was drawn last month to a recent McKinsey report entitled, Diminishing Returns: Why Investors May Need to Lower Their Sights.1

The thrust of the report was that investors’ current expectations for future returns have been shaped by actual returns enjoyed over the last three decades. Since these were unusually high, expectations for the future are now too high. The report notes that high returns over the past three decades were due to sharp declines in inflation and interest rates; high GDP growth that was the result of positive demographics, productivity gains and rapid growth in China’s economy; and even stronger corporate profit growth due to such factors as declining corporate tax rates. Some of these trends, the report argues, have now either stalled or gone into reverse, meaning that future returns will be lower, perhaps considerably so, than they were in the past.

I have sympathy with the conclusion, and in fact would add the cost of climate change to the list of factors that will increasingly impact growth – and indeed aggregate corporate profits – in the decades ahead.

As an investor, one has two choices: one can either accept the lower returns or one can do something about it. Or, to put it another way, you can either ‘be’ the market by investing in passive funds that will simply provide you with these lower returns, or you can seek to ‘beat’ the market by investing actively, thus enhancing your returns if done successfully.

It is therefore ironic that flows into passive funds appear to be accelerating (see FT article, Passive funds grow 230% to $6tn 2) at a time when market returns are in decline. Furthermore, if you need to make your savings pot last longer because you are going to live longer, you are effectively doubling your problem by going passive.

This is not to say that I think beating the market is straightforward. It clearly isn’t, as the plentiful evidence that most actively managed funds fail to beat their benchmark indicates.

I am thus dismayed that, as the FT article cited above notes, active managers have been “attacked by academics and consumer groups for not offering value for money.” Of course active managers do not as a group offer value for money! The reality is that active investing is not like Blackjack in which it is possible for everyone to win, but Poker, in which some win necessarily at the expense of others. The above attack is the equivalent of criticising lotteries on the basis that the vast majority of participants win less (i.e. nothing) than they spend to play.

This analogy is not a perfect one, because winning lotteries is about luck. If financial markets were efficient, and it was thus impossible to beat the market, I can assure you my savings pot would be stuffed full of passives.

But they’re not.

The prices of financial assets do not move randomly but exhibit pattern, meaning that price movements are a function of previous movements and are thus predictable (unlike random movements which are by definition independent and thus unpredictable). This assertion is not opinion but fact – there are plenty of statistical tests that have found pattern in financial markets. For example, when real interest rates are high, real returns from bonds will tend to be high (the converse is also true). Another one: when the dividend yield of a higher quality company’s stock is higher than the market average, the stock’s total return tends to be higher than the market average. (Another name for the pattern at work here is mean reversion.)

However, taking advantage of these patterns is harder than it might appear.

First, it requires a contrarian mindset. The reason why dividend yields or interest rates become too high in the first place is generally that the companies or economies in question get into difficulty (think about falling oil prices over the last couple of years that drove up yields of oil majors or the high inflation of the 1970s that drove up interest rates). It takes a strong mind to see such difficulties as opportunities rather than as things to fear. Such strength is rare in any walk of life – most humans prefer to be part of a group rather than to stand apart from it. And of course we humans are emotional beings – being fearful is a natural trait that we evolved to protect ourselves from genuine threats such as sabre toothed tigers and disease. Human nature will per se always be hard for humans to counter.

Second, spotting patterns in markets requires a fair grasp of mathematical concepts that is also fairly uncommon. Computers are now bypassing humans in this endeavour, enabling the emergence of so-called smart beta funds that seek to take advantage of patterns such as value, quality and momentum. But there will always be some scepticism about putting your savings in the hands of computers, and thus mathematical nous will remain a valuable skill for so endowed active managers. Furthermore, smart beta funds themselves will likely by virtue of their buying and selling create other patterns that the skilled active manager can take advantage of. After all, any fund that invests according to a strict, and public, set of rules, whether traditional passive or smart beta, is essentially flagging to the world what it is about to do. It should be possible for active managers to work out how to profit from such knowledge.

Third, funds may become too big to be able to take advantage of market inefficiencies. Peter S. Kraus, chairman and chief executive of AllianceBernstein, recently wrote that, “Active equity managers as a group made two mistakes: one, as we grew quickly, we got complacent about our ability to effectively manage larger pools of assets. Then, with bigger portfolios to invest, many managers over-diversified their holdings as a way to reduce risk and preserve those assets.”3

I am reminded of Warren Buffett’s comment in a 1999 interview for BusinessWeek: “If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”4

Now, I have an awful lot more to prove than Buffett, and I’d be thrilled if I had a fraction of his ability, but I do know three things:
1. our Seneca funds are sufficiently small to be able to take advantage of investment opportunities that are out of reach for our bigger competitors,
2. I suspect they can grow several-fold before this advantage begins to wear off, and
3. if and when we reach that point, I will be very conscious as to any trade-off between further growth on the one hand and capacity to produce good performance on the other to prevent us growing further.

After all, my duty of care is to our investors as well as our shareholders.


1  http://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/why-investors-may-need-to-lower-their-sights
2  As at May 29, 2016
3 FT article, Why the era of the ‘closet benchmarker’ has to end
4 As quoted in “Wisdom from the ‘Oracle of Omaha’” by Amy Stone in BusinessWeek (5 June 1999) https://en.wikiquote.org/wiki/Warren_Buffett


The UK referendum

First it was David Cameron, then it was Gordon Brown, now it seems the markets have taken over the lead role of campaigning to stay in the EU. As the likelihood of Brexit has risen in recent days and weeks, sterling and equity markets have tumbled while safe haven Gilts have risen, presumably an indication of just how awful a vote to leave would be. The question is, how many people will this message from the markets sway?

This is not about facts any more, though I’m not sure it ever was. No one knows whether it would have been better to have been outside the EU these last few decades. And no one knows whether it will be better or worse to stay in. No, it is now down to pure psychology: the extent to which voters are either scared of the unknown or prepared, enthused even, to leap into it.

At the time of writing, the betting markets have the probability of a vote to stay at just over 60%. This is despite recent opinion polls putting the leave campaign ahead by a couple of percentage points or so. In other words, the betting markets are saying that the polls are wrong.

It wouldn’t be the first time. Despite adjustments that the polling companies make to ‘raw’ polling data, there are certain things they can’t account for, at least not accurately. For example, which way will the large number of undecided voters swing? Second, as alluded to above, to what extent will voters take note of the fears that are being very clearly expressed in financial markets? Third, voters may well express an opinion that is based on principle when polled that they may well not adhere to in the austere atmosphere of the polling booth. Fourth, it is not clear how voter turnout might upset the polls.

I can appreciate both sides of the argument – it would be stupid and reckless of me to say otherwise when the polls are so close. I can understand that many Brits are disillusioned by and mistrustful of politicians and the members of the so-called economic elite with whom they often fraternise. They may not care about the risk of being financially worse off if they can feel personally empowered in other ways. On the other hand, there are many who believe that while the club that is the EU is not perfect – in any club there are always going to be rules that members find irritating – it is better to be in one than not in one. (It’s more complicated than this of course but I think this summary captures the essential sentiments on both sides, if not the formal arguments of those leading the campaigns).

As far as the psychology is concerned, the 2014 Scottish independence referendum provides a good guide. There was a very similar pattern in that, in the lead up to the vote, the polls and betting markets narrowed sharply and as a consequence financial markets got the jitters. When the time came, the vote to stay (“No”) won comfortably, 55.3% to 44.7%. Furthermore, the turnout was a very high 84.6%.

In the UK referendum. the remain campaign is not hindered by the “No” label, the negativity of which may well have made the Scottish vote closer than it would otherwise have been.

My view is that the aforementioned psychological considerations will favour the ‘remain’ campaign more than the ‘leave’ campaign and that, like the Scottish referendum, the outcome will not be as close as the polls are currently suggesting.
If I’m wrong, what then?

Even in the event of the ‘leave’ camp winning, I suspect sterling and equity markets will bounce in the immediate aftermath of the vote. This is the nature of markets. The situation is akin to Pascal’s wager, in which the great 17th century mathematician argued that there was no downside to believing that God exists – if you were wrong, it didn’t really matter. Similarly, there is one can argue no downside today to investors taking the view that the ‘leave’ campaign will win and selling their shares. Yes, you might not capture upside, but you won’t lose money. The utility of not losing it seems is far greater than that of winning, also known as loss aversion.

The logic of this argument is flawed, but then reason has rarely been the driver of markets in the short term – that role has been taken jointly by ‘fear’ and ‘greed’. The fact is, it is always more dangerous to sell than to not sell. If you sell and you are wrong, you incur a permanent loss, albeit an opportunity loss. If you don’t sell and you are wrong, you just have to wait for things to recover, as they almost always do. The loss is very likely temporary, and thus not permanent.

This is the view we have taken at Seneca. We are slightly overweight equities because we think they are generally cheap and the economic outlook, while not great, is OK (and in the case of our UK companies we think they can thrive either way). We are prepared to ride out short term volatility to the extent our already diversified multi-asset funds are exposed to it, and we would strongly encourage others to do the same.


Strategic asset allocation (SAA) review

We have just concluded our annual review of our funds’ strategic asset allocations. We have made some small changes to the underlying assumptions but not to the weights themselves.

To recap, our strategic asset allocation for a particular fund is constructed so as to achieve a particular real return – once fund costs and expected value added are accounted for – over the long term, as well as good diversification. Ultimately, we believe that by achieving a certain real return, the fund in question will attain top quartile status over the medium to long term in relation to its respective peer group. The inputs to the calculation for a particular fund are thus: (a) the long-term expected real returns we expect each of the asset classes in which our funds invest to achieve; (b) the real return objective of the fund; (c) the value added we expect to generate from active management and (d) fund costs. While we are aware of the volatilities of and correlations between asset classes, we do not use complex optimisation models. We do however model the SAAs to check that they have achieved in the past what we want them to achieve in the future.

Changes to the long-term return assumptions can be seen in the table below:

Table 1: Asset class long term real return expectations

Table 1 - Asset class long term real return expectations

The changes relate only to equities and within equities to all regions/countries other than North America (for which read ‘US’).

The rationale for the changes is simple: we think that economic growth is likely to be lower over the long term across the globe. At the same time, we acknowledge that US companies are probably more dynamic than in other parts of the developed world, and also that a negative adjustment should be made for the poorer governance of companies in emerging markets. In sum, this means a 1 percentage point reduction everywhere other than in North America.

We have not made any changes to expected returns within fixed income or specialist assets.

As for assumptions about the value added we can generate through active management, we have increased our targets for UK equities and overseas equities from 2% to 3% and from 1% to 1.5% respectively. This is an acknowledgement of our mid cap focus in the UK (mid cap stocks over time have beaten large caps by a significant margin, something we expect to continue). As for overseas equities, we are making more use of our capacity to be more concentrated as well as our capacity to invest in smaller, more dynamic funds. Both of these we feel increase our scope to add value.


Inflation watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

Core inflation rates in the developed world have been fairly stable in recent months at around the 1.3% per annum level (see Chart 1). This is certainly an improvement compared with a year or so ago when the average was slightly below 1%, but is still short of where central banks would it to be. That said, core inflation in the US is around 2% which is where the Federal Reserve would like it to be (and hence why it has started to increase interest rates). In recent months, core inflation has started to trend downwards slightly in Europe and Japan – something the ECB and BOJ will be watching closely no doubt – but is still well above zero. Despite headline inflation numbers which are much lower as a result of food and energy price declines, central banks should be commended for maintaining price stability in recent years (with the exception of Japan whose success is more recent).

In the emerging world, the inflation picture continues to improve, with rates continuing to fall in Brazil and Russia, and stabilising around 2% in China (see Chart 2). India’s inflation remains a little higher than policymakers would like it to be, but it remains much lower than levels seen back in 2012 and 2013.

I have included this month a chart of year over year wage growth in developed economies (see Chart 3). As with core inflation rates, it is encouraging to see that wage growth in the US, the UK and Europe has remained in the 1.5-2.5% range, while in Japan it has risen from around -1% in 2013 to close to 1% currently. The assertion that Japan prime minister Abe is losing the battle against deflation is perhaps unwarranted.

Chart 1: Core consumer price inflation – developed economies

Chart 1 - Core consumer price inflation

Source: Bloomberg

Chart 2: Consumer price inflation – emerging economies

Chart 2 - Consumer price inflation - emerging economies

Source: Bloomberg

Chart 3: Wage growth – developed economies (YoY%)

Chart 3 - Wage growth - developed economies Source: Bloomberg


Employment watch

Most if not all central banks are tasked with maintaining price stability and full employment. This section looks at recent employment trends and what they might mean for monetary policy around the world.

May’s non-farm payrolls of 38,000 came in well below expectations of 160,000. Furthermore, April’s payrolls were revised downwards from 160,000 to 123,000. The unemployment rate fell from 5.0% to 4.7% as the workforce shrank (having been rising since September last year, the participation rate has fallen back in April and May). Chart 5 below puts these numbers context. While the poor payrolls are of some concern, it is too early to say that they are the start of something more pronounced. There have been several months during the last six years when payrolls have come in well below 100,000 but did not signal the start of a downward trend. That said, we are now closer to the point at which employment is more likely to start to fall, so these numbers should be taken more seriously.

One conclusion that can be drawn from the data is that the probability of a June or July rate rise from the Fed is now much lower.

Elsewhere, unemployment rates in Japan, the UK, and Europe continued to fall. As can be seen in Chart 4 below, the average of the four countries/regions still has some way to fall before it hits the low point in the previous cycle.

Chart 4: Unemployment rate – developed economies

Chart 4 - Unemployment rate - developed economies

Source: Bloomberg

Chart 5: US employment indicators

Chart 5 - US employment indicators

Source: Bloomberg

Corporate sector indicators

Sales per share is often an interesting indicator to look at. Charts 6 and 7 below do just that, the first by geography and the second by industry. While the first suggests that the decline in the total (world) sales per share is fairly broad, the second suggests the decline is concentrated in four sectors: energy, materials, financials, and utilities (indeed this pattern can also be seen in Chart 8 which shows operating profit margins by industry). Nevertheless, it is clear that sales growth in the current cycle has been much weaker than in the previous two cycles. This is a reflection of the weak economic growth posted since the crisis. Why growth has been weak is a hard question to answer. Renowned economist Larry Summers has put forward a number of arguments as to why growth has stagnated in the US, many of which may also apply in other major developed economies.

I shall be looking at Summers’ research in more detail in next month’s letter.

Chart 6: Sales per share by geography (trailing, Dec 1995 = 100)

Chart 6 - Sales per share by geography (trailing, Dec 1995 = 100) Source: Bloomberg

Chart 7: Sales per share by industry (trailing, Dec 1995 = 100)

Chart 7 - Sales per share by industry (trailing, Dec 1995 = 100) Source: Bloomberg

Chart 8: Operating profit margin by industry (%)

Chart 8 - Operating profit margin by industry (%) Source: Bloomberg


Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 2: Current fund tactical asset allocation (TAA) target weights(as of 31 May 2016, prior month’s targets in brackets)

Table 2 - Current fund tactical asset allocation - as of May 2016

      • No asset allocation changes in May for the OEICs
      • Minor asset allocation changes for the investment trust – fixed income increased to 7.0% from 6.6%, cash reduced to 1.0% from
        1.4%
      • SIGT: Introduced Britvic (target increased from 0% to 1.5%) and exited Aberforth Smaller Companies (target decreased from 1%
        to 0%)
      • Britvic’s yield of 3.3% offers good value in the context of stability of business and strength of brand
      • Aberforth exited on basis that the yield was not sufficiently attractive; also the holding did not align with our broad intention to invest directly only in UK
      • SDGF: introduced GCP Student Living (target increased from 0% to 1%), Aberdeen Private Equity Fund (0% to 0.7%), and exited
        NB Distressed Debt (1.7% to 0%)
      • GCP Student Living provides exposure to a niche and growing area of the property market and an attractive dividend yield of
        4.1%
      • Aberdeen Private Equity Fund continues to grow its NAV at a decent pace; it trades at a 33.3% discount to NAV
      • NB Distressed Debt exited on the basis that it does not provide the stability of returns that we seek from our specialist assets
      • SDIF: introduced Arrow Global Group (target increased from 0% to 1.0%), and reduced Fidelity Enhanced Income (2.0% to
        1.0%%)
      • Arrow Global is a market leader in acquisition of consumer debt; the company is growing earnings and dividend rapidly, yet its stock trades on a single digit P/E
      • Fidelity Enhanced Income reduced in line with move to replace indirect UK equity holdings with good value direct investments
      • SDIF: increased Royal London Sterling Extra Yield Fund (target increased from 4.0% to 4.6%), Royal London Global Short Duration High Yield Bond Fund (4.0% to 4.6%), and exited M&G Global High Yield Floating Rate Note Fund (1.2% to 0%)
      • The increases in the two Royal London funds were part of a further consolidation of fixed income positions, and also improved the income generation within SDIF
      • The M&G fund was exited as we felt the running yield of around 3% was unattractive given our view that a rise in UK interest rates that would benefit the fund is still some way off

Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 31.05.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested.
This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/103.

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Peter Elston’s Investment Letter – Issue 13: May 2016

24 May 2016

Introduction of our new investment process – one year on.

Our new investment process reached the grand age of one in April. We thought it might be useful for clients and other readers to take a look back at how things have gone during the first year.

To recap, we are a multi-asset specialist and have three public multi-asset funds: our investment trust Seneca Global Income & Growth Trust and our two OEICs, CF Seneca Diversified Income Fund and CF Seneca Diversified Growth Fund. Each has its own strategic asset allocation which is linked to its specific long-term return objective. For example, in the case of the Growth Fund we expect over the long term to achieve a total real return net of costs of 6%. To achieve this, its strategic asset allocation comprises 60% equities (20% in UK and 40% non-UK), 15% fixed income and 25% specialist assets. For internal purposes, we use this strategic asset allocation as the fund’s performance benchmark, assigning an appropriate market index to each of the sub asset classes e.g. US equities, emerging market debt and so forth. Indeed, since December 2000, the Growth Fund’s strategic asset allocation has achieved a real trend return of 5.2% per annum. When expected value added from tactical asset allocation and holding selection in each of the four asset classes as well as fund costs are taken into account, this would get us to a real return of 6% per annum. It should also be noted that the last 15 years have included two particularly nasty bear markets in equities, so this trend return would have been depressed compared with previous decades. That said, this trend rate would also have been boosted somewhat by the strong performance of safe haven government bonds over the period.

So, the theoretical modelling is consistent with our actual fund objectives. What is not clear of course, and never will be, is whether markets over the medium to long term will perform as expected. Perhaps more importantly, whether we will be able to generate the value added that we expect to is also not guaranteed.

Back to the process.

Without doubt the two most important aspects of our new investment process relate to our investment style and the organisation of our research effort.

An investment style describes a framework for how investment decisions are made. Employ many different investment styles and you not only reduce your chance of making money – think “Jack of all trades master of none” – but you are also very likely to confuse your investor base. But having a clear investment style is not enough: buying only those companies with the colour orange in their logo is exceptionally clear but has no empirical or theoretical basis (you could quite easily be Tangoed).

Our new investment style which we formally introduced a year ago is called “Multi-Asset Value Investing”.

What does this mean?

It means that every investment decision we make is on the basis that something is fundamentally cheap (decisions to sell are made if something has become expensive). For example, a tactical asset allocation decision to overweight a particular equity market is made because we believe that the market in question is under-valued. In the UK, we invest directly, so a decision to buy a particular stock is made because it’s under-valued. Outside of UK equities we generally invest in third party funds, so we’re looking for managers who have some sort of value-oriented approach or who have identified cheap assets in a particular specialist area.

The theory is simple: cheap assets are more likely to appreciate in value than expensive ones. The empirical evidence is strong as well: various studies have found that high dividend stocks have outperformed low dividend stocks and that bull markets have generally begun when equity market yields are high.

Buying cheap assets won’t necessarily dampen volatility in the short term – an under-valued asset can often move even further away from its intrinsic value before moving towards it. What it will do however is help avoid permanent loss of real capital in the longer term. An example of this is developed market long-term government bonds. With their negative real yields, they are guaranteed to lose you money if held to maturity. However, by not holding them, fund volatility in the short term increases slightly, as not only are they low volatility but they also tend to be negatively correlated with so-called risky assets.

As for our other major change, we introduced in April last year specialist research responsibilities for each member of the investment team. Whereas previously it was the named fund managers who would decide what was in their funds, across all asset classes, under the new process it is a team effort. For example, Rich is a named fund manager on our Income Fund but is also now our specialist assets research specialist. This means he is responsible for analysing investments in his specialist area and deciding which ones we should own for all of our funds. Alan, Mark and Tom are responsible respectively for fixed income, UK equities and overseas equities whilst I cover asset allocation (strategic and tactical).

Research specialists make precise recommendations that require the approval of at least two of the other four members of the investment team, with approval granted if it is felt that sufficient research has been carried out and that the recommendation fits with our value-oriented investment style. This approval process we think is an important risk control, since it would be unwise to allow decisions to be made without any scrutiny of them or indeed to place all the responsibility for a decision on the shoulders of one person. But it is also important that the process is not too onerous and that specialists are allowed the scope to define how they do things in their asset classes within the broad parameters relating to our investment style. We believe we have the right balance.

As a direct result of these two key changes we have increased the commonality of holdings across funds. Previously our Growth Fund tended to buy growth stocks and our Income Fund only higher yielders. Tactical asset allocation could also be inconsistent. Under the new process the Growth Fund is a growth fund not because it owns different investments because it has a higher exposure to risky assets. So it now has many holdings in common with the income fund. This means that greater consistency in investment performance will be seen across all our funds. More often than not, if one of our funds is doing well in relation to its peer group, the others will be too.

As far as implementation is concerned, the Income Fund and our Investment Trust were fairly closely aligned with the new investment style to begin with – both funds had income-oriented mandates which lent themselves naturally to a more value-oriented approach. The Growth Fund however still requires further alignment and there remain five or six holdings to be exited. Indeed, over the last year the Income Fund and the Investment Trust have performed very well in relation to their respective peer groups, while the Growth Fund has languished somewhat. This is a direct consequence of the extent to which funds were already employing a value-oriented approach. Holders of the Growth Fund are assured that it will be fully aligned with the new investment process by the end of the third quarter of this year. We expect this to result in better long-term returns for investors in the fund.

Looking back at one or two of our investment decisions over the last year that help illustrate how the process is working in practice, perhaps the best examples are to be found at the beginning of this year. Mark, as UK equities specialist, wanted to recommend the purchase of three UK stocks that he believed had become cheap. He had the option to replace or reduce some of his existing UK equity holdings but I as tactical asset allocation specialist believed it was appropriate to increase the equity targets, given the extent to which markets had fallen. The question then for me was how we should fund this increase, whether by reducing our fixed income or our specialist assets positions (we generally run low cash balances unless we think markets are very overvalued). Our fixed income allocations were already on the low side, so after consultation with Rich, it was decided to reduce specialist assets (Rich agreed that many of his specialist assets had held up well and in fact two or three of them had seen their yields compress as a result of strong performance).

The three UK stocks that we added to funds in January and February were Royal Dutch Shell, International Personal Finance (IPF) and Victrex (we have a bias towards mid-caps which not only tend to outperform over time but also are less researched so present better opportunities to find hidden gems).

When Shell fell to below £13 in January, its historic yield reached around 10%, clearly discounting a big and permanent cut in future dividends. We felt that although a big cut was very possible (and still is), the high yield presented a big margin of safety – a 50% cut would still leave the shares yielding above 5%. Furthermore, although Shell’s upstream business was under pressure as a result of the low oil price, its downstream business was doing just fine, and in fact was to some extent benefitting from low oil prices. Finally, as far as the upstream business was concerned, Mark had noted that the forward oil curve was extremely steep, with prices two years out around 50% above prevailing spot prices. This suggested the spot price was particularly depressed for technical reasons such as speculative shorting or storage issues, and would thus likely rise. We bought the shares at an average of around £13.50. As of 12 May, they were trading at £17.54.

As for IPF, this is an emerging market home credit provider that had been spun out of Provident Financial in 2007. By 2013, the stock was a darling of growth fund managers, and the shares traded on a high valuation. In recent years however, countries in which it operated have introduced interest rate caps, which impacted the stock. Early this year the shares hit a yield of close to 6%, compared with well below 2% in its heyday. Now, interest rate caps may on balance hurt IPF’s business, but by no means terminally. Even at lower rates, the company is still able to find sufficiently high quality credits. Two other things. First, the mostly female agents get to know their mostly female customers by visiting them often and they are rewarded not on how much they lend but on how much they get back – a hark back to the early days of banking! Second, when governments realise that by introducing interest rate caps they are simply playing into the hands of loan sharks, they may well reconsider the legislation.

Outside of UK equities, a specialist asset that is illustrative of the new process is AEW UK REIT plc (indeed we purchased it at IPO in May 2015 and it was the first purchase made in any asset class under the new process). While we felt that prime property was becoming expensive, AEW was interesting because it was non-prime in the sense that it was focussing on smaller lot sizes, with shorter leases, and properties that needed more asset management (refurbishment). The management team was targeting 8-9% yields once fully invested, with dividends fully covered by income. Active asset management of the properties would be expected to bring total returns into the teens. We met the team in Liverpool and liked them. Since listing, the shares have returned 2.8% compared with a fall in the broad UK equity market of close to 10%. Furthermore, the annualised volatility of the shares has been 7.7%, nearly half that of the equity market.

To conclude, we have a unique and strong investment proposition. As an active manager, to produce good investment performance for investors, it is not only preferable to be different but essential – follow the crowd and you’re very likely to end up with poor performance net of costs.

We are different in a number of ways. We know that our “Multi-Asset Value Investing” investment style is unique – Google the term and you’ll only find Seneca. Buying things cheaply sounds like such an obvious thing to do but surprisingly few seem to follow the doctrine, at least in a formal, organised way. Investing directly in the UK and in mid-caps is also different and allows us not only to improve investment performance but to avoid the costs associated with third party funds. We have what we think is a high allocation of 25% of all our funds to specialist assets. These are mostly listed on the LSE, and in many cases offer high yields and stable, index-linked cash flows. Examples would be specialist REITs, asset leasing vehicles and renewable energy funds. They not only offer an alternative to equities but also to bonds. Finally, we have a well organised portfolio management and research system, with specialists responsible for maintaining target weights in their area of responsibility, for every mandate we manage. Named managers are given some discretion to deviate from targets but there are strict limits.

The new investment process has been well received and scored a number of successes in its first year. We thus hope and expect returns to continue to improve. So, on the occasion of its first birthday we extend to all our investors, the prospect of many happy returns.


Inflation watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

It is interesting that despite rising concerns about the outlook for global economic growth in recent months, there has been no noticeable decline in core inflation (CPI less food and energy) across the developed world (see chart 1). Indeed, core inflation has actually been rising over the last 12 months in the US, the UK and Japan, though there has been a slight decline in Europe. The simple average for the four series is 1.4% as of March which although below what should be considered the target for developed country central banks, is not cause for serious concern. On the contrary, it means that monetary policy will remain loose which should be supportive of risky assets (bear markets tend to start when central banks are trying to bring inflation down).

As for emerging countries, there are signs of improvement (see chart.2). China’s inflation rate, which has been too low, has been rising, while Brazil’s and Russia’s, which have been too high, have been falling. India’s has been nudging up to around 5% over the last couple of years. This might be considered slightly on the high side, though is a vast improvement on the 10% rates seen in 2012 and 2013.

Chart 1: Core consumer price inflation – developed economies

PE IL 13 - May 2016 - Chart 1
Source: Bloomberg

Chart 2: Consumer price inflation – emerging economies

PE IL 13 - May 2016 - Chart 2
Source: Bloomberg

 


Employment watch

Most if not all central banks are tasked with maintaining price stability and full employment. This section looks at recent employment trends and what they might mean for monetary policy around the world.

Unemployment rates across the developed world have continued to improve (see chart 3). There seems to have been some fall in the rate of improvement in the US, the UK and Japan but this is only to be expected given that unemployment rates have been falling since 2009 (in Europe, unemployment only started to improve in 2013, and from much higher levels, so there the pace of improvement is if anything rising). The average of the four series stood at 5.9% as of March which should mean there is still plenty of scope for it to fall further. Indeed, during the last cycle from 2003 to 2008, the unemployment rate continued to fall for a further three years or so after it first hit 5.9%.

Furthermore, there are reasons to think that it can fall further and for longer than it did during the last cycle. In the case of the US, for example, although the unemployment rate has fallen a long way already, this masks the fact that the workforce has shrunk as a result of people having left the workforce. If as a result of the continued improvement many of them decide to re-enter it, this could well prolong the cycle (in fact this has started to happen, as evidenced by the rising participation rate). Second, there is evidence to suggest that the unemployment rate at which inflation starts to rise (also known as the NAIRU – the non-accelerating inflation rate of unemployment) has fallen. The Fed’s estimate of NAIRU fell from 5.6% in 2013 to 4.9% towards the end of last year. There is no reason to think it hasn’t fallen further since, meaning that employment may continue to rise without causing the Fed a headache.

As for emerging economies, data is sparse (see chart 4). Brazil is undergoing a nasty recession but the improvement in the inflation picture as noted in the previous section is encouraging.

Chart 3: Unemployment rate – developed economies

PE IL 13 - May 2016 - Chart 3
Source: Bloomberg

Chart 4: Unemployment rate – emerging economies

PE IL 13 - May 2016 - Chart 4
Source: Bloomberg


Other business cycle indicators

The OECD calculates leading indices every month for a large number of countries. Chart 5 below shows the year-on-year change in the leading indices for the UK, the US, Europe and Japan, as well as the four BRIC countries. It can be seen that the average growth rate over the last five or so years has been considerably lower than the 6% or so rate that prevailed prior to the 2008 financial crisis.

However, it is still positive at around 2% and appears to be stabilising. This stabilisation is evident in chart 6 below which shows the rate of change of the rate of change of the average (known as “the second derivative”). I would suggest that this is an improvement that has yet to be fully appreciated by equity markets.

Chart 5: OECD composite leading indicators (trend restored YoY%)

PE IL 13 - May 2016 - Chart 5
Source: Bloomberg

Chart 6: The rate of change of the average in Chart 5 (“the second derivative”)

PE IL 13 - May 2016 - Chart 6
Source: Bloomberg


Table 1: Current fund tactical asset allocation (TAA) target weights (as of 10 May 2016, prior month’s targets in brackets)

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.
PE IL 13 - May 2016 - Table 1
Source: Seneca Investment Managers, 10 May 2016

  • No asset allocation changes in April.
  • Introduced Primary Healthcare Properties (PHP) to all portfolios via its £150 million fundraising; having sold Assura earlier in the year on valuation grounds, PHP’s higher yield combined with its strong track record allowed us an opportunity to regain exposure to this interesting sector.
  • The purchases of PHP were funded by sales of Ediston Properties whose shares Rich felt had become too illiquid. He also felt that new stamp duty rules would make it harder for the management team to grow the REIT going forward.
  • Our investment trust sold its holding in BHP Billiton during the month, with proceeds moving into Arrow Global (a stock that was already held in the growth fund). Mark felt that the 70% rise in the share price since January presented an excellent opportunity to sell the holding, particularly given that both he and I felt the rally in commodity prices that had driven the appreciation was unsustainable.
  • The Growth Fund sold its holdings in its emerging markets healthcare ETF and its China fund (in favour respectively of the Somerset Emerging Markets Dividend Growth Fund and the First State Asia Pacific Leaders Fund). These sales were part of the aforementioned realignment of the Growth Fund, with neither fitting our investment style. The recipients of the proceeds are both funds that have good track records and value-oriented styles.

Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 30.04.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested.
This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/84.

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Peter Elston’s Investment Letter – Issue 12: April 2016

18 April 2016

Introduction:

During a break at a conference I attended recently I was chatting to someone who said he thought that multi-asset investing was a gimmick. I tried hard to smile, saying simply that the idea of spreading one’s investments across different types of assets was as old as the hills, which it is.

But the reality is that multi-asset investing does have a bit of an image problem and as a multi-asset specialist we have to deal with that. Part of the problem, as with so much in our industry, relates to the use of jargon. When I began my career in 1988 with a large UK fund management house, most of the firm’s assets under management were “multi-asset” – in the form of defined benefit pension scheme assets. Many of these funds had around half their assets invested in UK equities, another fifth or so in overseas equities, another fifth in bonds and the rest in property and cash. To all intents and purposes they were multi-asset funds. We just didn’t call them “multi-asset”.

Then, over the course of the next couple of decades, the consultants took over, recommending to pension fund clients which manager they should select to manage which bucket of assets. They themselves would take on the job of asset allocation, while fund managers would be picked on the basis of their selection skills in equities, bonds or other asset classes.

To be fair to the consultants, the asset allocation function was ripe for an overhaul. At the firm where I started, it was the manager of the UK equity portion who was the central figure, with the job of asset allocation left to one individual who every quarter would look at the positioning of other pension funds as provided by CAPS or WM and tweak weightings accordingly. It was not sophisticated and the investment consultants, with their clever mean-variance optimization models, had a field day.

However, retail and wholesale demand for what would commonly become known as multi-asset funds was starting to rise. Alongside this, the absolute return fund came into being, as well as numerous other ways of making asset allocation decisions with the aim of generating good volatility-adjusted returns. As of 11 April, there were 573 OEICs across the six IA sectors that are either strictly multi-asset or, as is the case with targeted absolute return, have objectives that can be thought of as similar to those of multi-asset funds. The multi-asset landscape it seems is one that is competitive for us and confusing for our client base.

The way we try to address this is to get a good balance in our funds between simplicity and sophistication. The sophistication comes in the form of:

  • good diversification at an asset class level across equities, bonds and specialist assets that helps dampen volatility in the shorter term (though we certainly don’t purport to be absolute return managers);
  • a value oriented investment style that identifies assets which are undervalued and should thus perform well over the longer term;
  • a high conviction approach with respect to tactical asset allocation and security/fund selection that ensures funds are given the potential to produce value added in excess of fund costs.

The simplicity aspect is about steering clear of complex structured products, derivative strategies and hedge funds, as well maintaining a longer-term investment time horizon. Look at our funds’ holdings as well as our portfolio turnover and it should be pretty clear what we’re trying to do, something that we don’t think can be said of that many of our competitors.

Another major trend that was already underway in the late 1980s was the move towards passive investing. This trend was centred on equity funds where it was plain for all to see that the average actively managed fund in a particular geography underperformed its benchmark or the relevant benchmark index. More recently, funds that are designed to track more complex indices that are tilted towards a particular subsector or factor such as high dividend yield or high quality have grown in popularity. These funds are known as smart- or strategic-beta funds.

Although at a much earlier stage, there is a similar move towards passive and smart beta happening in the world of multi-asset. However, although similar, there are some key differences.

First, multi-asset funds use different types of benchmark, unlike equity funds that mostly use a stock market index (and in a particular geography, one benchmark index tends the prevail, an example being the S&P 500 index in the US). Some multi-asset funds use a composite index, the simplest being a 50/50  equity/bond index, some use the relevant peer group average, some use a nominal fixed return, some a real fixed return, and others still do not specify a benchmark at all.

Second, multi-asset funds, even within the same sector, can also vary enormously with respect to the volatility of their returns. Look at one of the IA multi-asset sectors and you will see a wide range of volatilities, unlike equity land where the ranges tend to be much narrower.

Third, and this is related to the first point, there are few ‘independent’ composite benchmarks in existence and fewer still funds that employ them. One example is the Dow Jones Global Composite Yield Index that is itself comprised of indices in five asset classes: equities, real estate, alternatives, corporate bonds, and sovereign bonds. However, although the first three of these are their own, Dow Jones uses Credit Suisse indices for the last two. Furthermore, I have been unable to find any funds that actually use it as their benchmark. All passive multi-asset funds that I have come across use their own composite benchmarks. Active funds that use a composite index as a benchmark also tend to create their own using different indices from different providers.

The world of multi asset does not easily lend itself to smart beta either. In the world of equities, it is now well understood that there are certain factors that tend to perform well over time such as smaller companies or stocks with high dividend yields. Furthermore, it is also well understood that creating indices to capture these factors is fairly straightforward.

Not so in multi-asset.

There have been attempts to create multi-asset indices whose weightings in underlying assets classes vary according to certain systematic rules. But these rules are necessarily bespoke and thus not becoming universally accepted and understood, as is the case in equity land. Their mystique may prevent them from enjoying the same success. The risks of something going wrong are surely too great.

Perhaps the biggest problem I see with passive multi-asset funds is that they may naturally have a significant and permanent weighting towards what are now extremely expensive government bonds. This may mean that they perform well over the short term, as has certainly been the case in recent months, but the negative long-term real yields that prevail in most if not all advanced countries mean one thing: over the longer term they are guaranteed to lose you money in real terms.

At Seneca, we believe that our active approach to multi-asset, one that avoids obviously expensive assets, is one that will over time produce stronger performance than a passive equivalent. Our volatility-adjusted investment performance numbers we think show just that.

 


Inflation watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

As anticipated, inflation turning negative in the Eurozone in February did indeed prompt drastic action by the ECB, which announced a greater than expected increase in asset purchases. Elsewhere, it is encouraging to see Japan’s headline and core inflation numbers rising slightly in February, though no doubt the recent Yen strength will dampen prices down the line. As for emerging markets, both Brazil’s and Russia’s inflation rates have been falling noticeably which should be welcomed, though in both cases the numbers remain well above what would be considered comfortable levels.

Table 1: Inflation data releases over past month

IL 12 Table 1 Inflation data releases over the past month


Employment watch

Most if not all central banks are tasked with maintaining price stability and full employment. This section looks at recent employment trends and what they might mean for monetary policy around the world.

Unemployment in most regions remains above what might be considered full employment though we are getting close in the US and the UK. In the US, we are finally starting to see a rise in the participation rate, as those who previously left the workforce are being encouraged to return. This suggests employment can continue to rise for a while longer without impacting the unemployment rate and thus wage costs.

Table 2: Employment data releases over past month

IL12 Table 2 Employment data releases over past month


 

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 3: Current fund tactical asset allocation (TAA) target weights (as of 12 April 2016, prior month’s targets in brackets)
IL12 Table 3 Asset allocation
  • During March we increased the overall equity TAA target weight for all funds by 1 percentage point. This was something we had anticipated doing at some point, having in February raised cash by reducing the target in specialist assets.
  • The 1 percentage point equity target increase was spread across global funds, where we increased the target in Blackrock World Mining Fund, and Asia Pacific ex Japan.
  • Blackrock World Mining Fund remains very attractive, on a historical yield of 9.9%. It is very possible that the dividend will be cut this year, but even factoring this in, the yield is attractive.
  • As for Asia Pacific ex Japan, we think the region is becoming more attractive, having been underperforming for the last few years.
  • Elsewhere, we exited UK holding UBM plc for all funds. Following a very strong run since early February, the valuation is now less attractive. The current 17 times prospective PE is the highest since before the financial crisis.
  • The reduction in the UBM target was reassigned to different holdings depending on the fund. Indeed, our UK equity specialist took the opportunity to increase the commonality of holdings across portfolios.

Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 31.03.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.
Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/67.

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Peter Elston’s Investment Letter – Issue 11 March 2016

14 March 2016

Executive summary:

I will be writing an opinion piece about emerging markets later this month for one of the trade journals. Here are some preliminary thoughts.

The big question with respect to emerging markets is when they’ll start performing. Since the second half of 2010, emerging markets have fallen by 45% in relation to developed markets. That by any standards is substantial and has prompted some to suggest that a change of fortunes is imminent. It is particularly interesting given that over the same period the MSCI AC World Growth index has outperformed its ‘Value’ counterpart by 15% (and by 29% since the end of 2006). If emerging markets embody anything it is ‘growth’, surely!

The term ‘emerging markets’ was coined in the early 1980s by then World Bank economist Antoine van Agtmael. He was trying to launch a fund investing in the new asset class and was persuaded that ‘The Third World Fund’ wasn’t sexy enough. Ever since, emerging markets have been considered a great place to invest.

Goodness knows why!

Since the end of 1987, emerging markets have returned 7.4% annually in US dollars. This compares with returns from US equities of 7.7% annually. Given that emerging market equities have been far more volatile than US equities and that economic growth has been much higher, you’d have expected equity returns to be much higher.

Why haven’t they been?

It is hard to generalise about a region that constitutes 23 countries and well over 800 companies but a key problem is that high economic growth has not filtered down to minority shareholders. Nowhere is this truer than China. Since 1992, China’s nominal GDP has increased 2,217%. Its stock market however has only risen 17% including dividends, equivalent to 4.1% in US dollar terms. On an annualised basis, 4.1% equates to 0.2% per annum. Where on earth did all that GDP go?!

Minority shareholders are just one of several stakeholders in any company. Others include employees, regional and central governments, and local suppliers. It seems that foreign investors who have poured money into emerging markets over the years have sorely underestimated the extent to which these other stakeholders would take their pound of flesh. In China’s case, raising wages has been a core tenet of government policy. This has been great for Chinese workers but will almost certainly have been at the expense of earnings per share.

Higher economic growth can be a double-edged sword. It has certainly been the main reason why foreigners have poured money into emerging markets but arguably is also the main reason why investment returns have been poor. Investment opportunities appear plentiful in emerging markets, where incomes are generally low and the scope to increase productivity is high. Companies with grand investment plans tended to be the ones that attracted greater foreign interest and thus cheaper equity finance. Returns on that investment have often fallen far short of expectations, unless of course you were one of the other stakeholders.

This point is one that was well made in a paper written in 2012 by Yale professor Martijn Cremers titled “Emerging Market Outperformance: Public-traded Affiliates of Multinational Corporations”. Cremers noted that the really strong performance in emerging markets has come not from the headline-grabbing, capital-absorbing local companies but from the listed affiliates of MNCs, which tend to have pretty dull businesses such as fast moving consumer goods. The combination of dull businesses and strong governance that permeated down from the parent made for a potent mix.


Chart 1: Value of US$1 invested in June 1998

Peter-Elston-Letter-March-2016-1

Source: Martijn Cremers – Emerging Market Outperformance: Public-traded Affiliates of Multinational Corporations

Cremers identified 92 such listed affiliates across emerging Asia, Eastern Europe, Africa and Latin America and found some startling results (see chart 1). Over the period under review, the 92 listed affiliates returned on average a total of 2,229% in US dollar terms. This compares with 1,157% for countries in which the affiliates were listed and 371% for emerging markets broadly (the affiliates tended to be listed in the better performing emerging markets).
The moral of the story is that one should be very selective in emerging markets. Companies with aggressive expansion plans have tended to disappoint while the dull and careful have delivered. In emerging markets, the tortoise wins the race.

Finally, a look at valuations. As can be seen in chart 2 below, there has been a stark divergence in price-to-book ratios of emerging and developed market companies. The gap may look appealing compared to where valuations were a few years ago but it has at times been much bigger. Back in the late 90s following the Asian financial crisis, the price-to-book ratio fell to 0.3 times at a time when the tech bubble was powering developed market companies to well over 3 times. While it is hard to imagine emerging markets getting that cheap again, it is worth remembering that if the return on capital is less than the cost of capital, as is often the case with emerging market companies, one should not pay more than 1 times book.


Chart 2: Price-to-book ratio of emerging markets versus developed markets

Peter-Elston-Letter-March-2016-2


Inflation watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

Table 1: Inflation data releases over past month

Peter-Elston-Letter-March-2016-3

Source: Bloomberg  Mar 2016: Actual data was higher than/lower than/same as survey/prior/desired)

Perhaps the most important number coming out of the developed world was Europe’s February inflation turning negative. This prompted expectations of aggressive action by ECB president Mario Draghi at the central bank’s 10 March meeting. At the time of writing, the markets are coming off a little following what was a few hours ago a very positive reaction to the various stimulus measures announced by the ECB.

 


Employment watch

Most if not all central banks are tasked with maintaining price stability and full employment. This section looks at recent employment trends and what they might mean for monetary policy around the world.

Table 2: Employment data releases over past month

Peter-Elston-Letter-March-2016-4

Source: Bloomberg March 2016

Despite fears of slowing growth, unemployment rates almost everywhere came in lower than expected and, with the exception of Brazil, lower than or the same as the prior month. I’m still inclined to think that economies generally will continue to grow this year.


Current fund targets (as of 3 March 2016, prior month’s targets in brackets)

The targets in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 3: Current and previous target weights of our three public funds

Peter-Elston-Letter-March-2016-5

Source: Seneca Investment Managers, March 2016

  • Having increased the total equity weight by 2%pts in January, we increased it by a further 1%pt in February for all three funds via an increase in the UK equity target.
  • This brought the equity overweight to 5%pts in relation to strategic asset allocation.
  • We think that growth will remain sufficient this year to keep equities supported; however, if this is not the case and markets resume their downward trend, we have plenty of powder dry to increase the equity target further.
  • The 1%pt increase in the UK target was both top down and bottom up driven; we feel that the market is reasonably good value but the decision was also driven by our UK equity specialist putting forward a new stock idea.
  • The idea in question is International Personal Finance (IPF), a home credit provider operating in Poland, Lithuania, Romania, Bulgaria, Czech Republic & Slovakia, Hungary, Spain and Mexico.
  • The mostly female agents are remunerated based on loan repayments rather than the amount of loans extended, so are incentivised to get to know their mostly female clients well and to scrutinise credit risk.
  • The business has been impacted in recent years by interest rate caps introduced by governments of some of the companies in which they operate.
  • This has impacted sentiment towards the stock, which has fallen 60% from its highs in 2013 and is now yielding above 6%.
  • There is risk that governments in other countries in which they operate will also introduce interest rate caps but we think this risk is priced into the stock.
  • Furthermore, the unintended consequence of introducing interest rate caps is that borrowers are forced into the hands of loan sharks.
  • Thus there is also the possibility that interest rate caps are either removed or adjusted as politicians realise the errors of their ways (to the extent that politicians ever do!)
  • Elsewhere in portfolios, we reduced ‘specialist assets’ targets in anticipation of increasing further our equity targets; targets in specialist healthcare REIT Assura were reduced to zero as good performance had pushed the yield down to unattractive levels.

Download this investment letter as a PDF



Important Information

Past performance is not a guide to future returns. The information in this document is as at 29.02.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.

The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

CF Seneca Funds

These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).

Seneca Global Income & Growth Trust plc

Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/52.

 

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Peter Elston’s Investment Letter – Issue 10 February 2016

8 February 2016

It is possible that we are now in an environment in which the falls in markets since last summer, particularly those in early December and throughout most of January, begin to have an impact on aggregate demand (which anyway was already somewhat insipid what with on the one hand the US nearer the end than the beginning of its business cycle and on the other hand China slowing structurally). If people or companies feel more uncertain as a result of market declines, they may reduce their spending or investment patterns which could cause a recession.

How one judges whether this will happen and thus whether a protracted bear market looms is an almost impossible task. The global economy is an example of what is known as a non-linear complex adaptive system. Or to put it another way, it’s unpredictable. Fear can spread like wildfire, feeding on itself. And fear can be rational, as in bumping into a tiger, or it can be irrational, where one is fearful for no reason other than that others are fearful. Whether the crowd’s fear is itself rational is neither here nor there. Why wait to find out? It is human nature to run first and ask questions later. This reminds me of the conversation in Joseph Heller’s classic novel Catch 22 between Yossarian and Major Danby: “But, Yossarian, suppose everyone felt that way?” to which Yossarian replied, “Then I’d certainly be a damned fool to feel any other way.” You cannot argue with the logic.

You may think me barmy but below is my favourite chart (Chart 1). It depicts book values over the last 15 years of portfolios invested on 31 Dec 2000 in various MSCI indices, rebased to 1. In other words, no account is taken of subsequent movements in equity markets, only of dividends received. The series are calculated by simply dividing the total return indices by the respective capital only indices. Think of them as the accumulated value of dividends received (if you look carefully you can just about discern a slight flattening of the lines in 2009 when dividends fell, meaning that the rate at which dividends accumulated fell slightly).

Chart 1: Dividend indices – accumulated value of dividends derived by dividing total return indices by capital only indices

Source: Bloomberg Dec 2015

The point of the chart if you haven’t realised it is this: if dividends are so stable, why are markets so volatile? (I keep a copy of this chart pinned up on the wall near my desk to remind me to keep wondering about this question). The fact is that dividends in aggregate rarely fall and when they do they recover quickly. Why do markets sometimes behave as if dividends are going to dry up for good when the likelihood of this happening is so remote? Furthermore, why worry about this possibility when the circumstances that would cause it such as a nuclear holocaust or an asteroid hit would almost certainly cause you to worry about things other than the value of your portfolio. The answer to both of course is: human nature. Humans run first and ask questions later.

What this means of course is that if you step back and behave rationally, you can take advantage of the irrational behaviour of the crowd.

In 1981 Yale’s Bob Shiller wrote a paper titled “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?”

In the paper, Shiller noted that it had “often been claimed in popular discussions that stock price indexes seem too “volatile,” that is, that the movements in stock price indexes could not realistically be attributed to any objective new information [about dividends], since movements in the price indexes seem to be “too big” relative to actual subsequent events.”

To illustrate the point graphically, he plotted (see Chart 2 below) the S&P Composite index, P, against the present discounted value of the actual subsequent real dividends, P* (both series were de-trended so one could more clearly see the variations around the trend). What is clear from the chart is that the answer to the title of Shiller’s paper is ‘yes’, stock prices do indeed move too much to be justified by subsequent changes in dividends.

Chart 2: Actual S&P composite index and theoretical value based on discounted future dividends (both de-trended)

Source: Robert Shiller, 1981

Shiller’s paper dispels the notion that stock markets are efficient. Markets are simply too volatile to be justified by big changes in discount rates (real interest rates) or by people being rightly fearful of collapses in future dividends. Given that dividends haven’t collapsed in the past and that the sample size is large, it is highly unlikely that they will in the future. Companies have the ability to adapt to prevailing conditions. In the face of lower earnings, they can cut payout ratios in order to maintain dividends. They can cut capex, costs or prices. In the face of higher inflation, they can raise prices. All this means that companies in aggregate have a remarkable propensity to deal with and recover from recessions.

Shiller’s key conclusion is that markets are not efficient. If markets were efficient, they would track much more closely the present value of future dividends, something that can be reasonably estimated and which is very stable. Thus when markets veer a long way from the present value of dividends as they have a tendency to do, they will naturally be drawn back towards it, also known as mean reversion. This means it is possible for tactical asset allocation to add value.

To illustrate further this tendency for markets to recover, I have investigated how the US equity market has behaved following instances when it has fallen by various amounts in relation to its all-time high. Specifically, I have calculated how long it has taken the S&P 500 index to recover its all-time high once it falls certain percentages from said all-time high and what the annualised return has been during these periods. As of 20 January 2016, the S&P 500 was 12.7% below its all-time high attained on 21 May last year. Thus, I have considered all other periods since 1955 when it has fallen by the same amount, as well as by 20%, 30% and 40%. The results are shown in Table 1 below.

Table 1: Evidence of mean reversion in US equities

Source: Bloomberg, 20 Jan 2015

On the 13 occasions since 1955 when the S&P 500 has fallen by 12.7% from its all-time high, it has taken an average of 581 days (roughly 2 years) to regain its high, during which time the annualised return has been 6.3%. This is in fact slightly lower than the long-term average of 6.6%. However, when the index falls by more than 20%, the annualised returns to get it back to its all-time high have been well above 6.3%.

What this means is that judging by the history of the last 60 years a decline in the order of what we have seen over the last 8 months should not prompt one to increase equity weightings. However, if the market falls further, one should begin to get excited. And one should continue to get more excited the further the market falls. Gamblers call this a Martingale strategy and it works when applied in markets where there is mean reversion as is the case in equity markets.

Although it is certainly possible that we have entered a protracted bear market in equities, I don’t believe this to be the case. Economies around the world still in general have scope to grow, as evidenced by negative output gaps, low inflation, and unemployment rates that can fall further. Monetary policy can remain supportive (as we go to print Japan has introduced negative interest rates). And there is also scope to boost fiscal policy if necessary, though this would more likely be a response to a recession rather than slower growth. As for equity valuations, dividend yields are well above historic averages, which in the absence of a nuclear holocaust or asteroid hit represent good value. Thus, I don’t think markets will continue to fall for much longer but if they do we will be ready.

 


Inflation watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

 

Table 2: Inflation data releases over past month

There are very tentative signs of improvement in inflation numbers around the world (improvement could mean it either rising if it is too low or falling if it is too high). Numbers in Japan and the UK, while still below desired levels, were higher than both prior month and survey. Among the BRICS countries, China and India saw a similar pattern, though inflation rates in Brazil, Russia and South Africa were still high and rising.

I remain of the view that although monetary policy is not a cure for all ills, it can certainly help to get inflation back to desired levels in the medium term. For further reading, I would recommend former Fed governor Ben Bernanke’s 2002 speech Deflation: Making Sure “It” Doesn’t Happen Here. Below is an extract:

By increasing the number of U.S. Dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in Dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

I do not believe as some do that QE has failed. Frankly, what choice did central banks have once short term rates hit the zero bound? To get out the white flag and give up? Although headline inflation rates across the developed world are very low and in some cases negative, this is largely the result of falling commodities prices, in particular the oil price. Taking out food and energy, inflation is not so worryingly low. Yes, it will likely be a long haul, but central banks have come a long way from the policy errors of the Great Depression. And even Germany now understands that in combination with sensible fiscal policy, QE does not have to lead to hyperinflation.

 

 


Employment watch

Most if not all central banks are tasked with maintaining price stability and full employment. This section looks at recent employment trends and what they might mean for monetary policy around the world.

Table 3: Employment data releases over past month

Source: Bloomberg

On the whole, labour markets in key global economies continued to improve. Brazil’s unemployment rate unexpectedly fell in December, though it is hard to conclude at this point that this is definitively good news in light of rising inflation and the nasty recession that Brazil is experiencing currently.

 


Specialist investments

We have decided to stop using the term ‘alternative investments’ to describe our investments that are neither equities nor bonds, and instead will use ‘specialist investments’. We have found that the term ‘alternatives’ tends to be associated with potentially high risk vehicles such as structured products, hedge funds, art, wine, coins, and stamps, none of which as a matter of policy we would invest in. What we are looking for in this area are investments that genuinely offer something of value in relation to equities or bonds. For us, this means income streams that are more stable than those of equities and more real (index-linked) than those of bonds. It also means yields that are generally higher than equity market yields. And finally, most of our specialist investments are listed on the London Stock Exchange.

We have four sub asset classes within the broad ‘specialist investments’ segment: REITs, private equity, specialist financial and infrastructure. While we considered using the term ‘real assets’ which others are using, we felt that this term too was misleading, suggesting as it does investment in the aforementioned non-yielding art, wine, stamps etc. What links all four sub asset classes is that they are ‘specialist’ in some way or another. So, we have decided to use the term ‘specialist investments’.

Table 4 below provides data on seven of our ‘specialist’ investments. The message is a simple one: our specialist investments have been great ‘diversifiers’. The seven in question have all outperformed and been less volatile than the broader equity market since listing, and have all been lowly or in some cases negatively correlated with the broader equity market.

Table 4: What do our specialist investments bring to our portfolios?

Source: Bloomberg

On a related matter, we have now aligned the strategic asset allocation within CF Seneca Diversified Growth Fund’s specialist investment segment with those of our other two public funds. Previously, the growth fund had a small allocation to commodities and a lower allocation to REITs. We felt that in the case of commodities, since physical commodities do not yield anything they are hard to value and thus should not be part of our strategic asset allocation. As for REITs, we felt there was no good reason why the growth fund should be any different to the other two funds. REITs may not be as ‘growthy’ as equities, but they can provide a good alternative to bonds (in the credit space rather than safe haven space).

Table 5 below sets out the strategic asset allocation weights within our ‘specialist investments’ segment, showing that all three funds now have the same weightings in this area.

Table 5: Strategic asset allocation within ‘specialist investments’, as percentage of total (previous in brackets)

Source: Bloomberg

 

 


Current fund targets (as of 22 January 2016, end Nov ‘15 targets in brackets)

The targets in Table 6 below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example. Note that since we did not include the below table in the January letter which was dedicated to the 2016 outlook, we are using end November targets for comparison.

Table 6: Current and previous target weights of our three public funds

Source: Seneca Investment Managers, Dec 2015

 

  • We increased equities target across the funds in early to mid-January from 2 percentage point overweight to 4 percentage point overweight, funded out of a combination of cash, fixed income, and specialist investments
  • This increase was driven more by bottom up factors and was all in UK where our UK equity specialist was keen to introduce two names, Victrex and Royal Dutch Shell
  • Victrex is the world’s largest producer of polyether ether ketone, a high performance polymer for which new uses and users are continually being found by the company; 3.2% dividend yield to Sep 2016 which we think is attractive given growth prospects and balance sheet with net cash; special dividends also likely over next two years
  • As for oil major Royal Dutch Shell, this was very much a contrarian investment idea; the shares had fallen materially over 2014 and 2015 and we felt the 10% dividend yield was extremely attractive even if the dividend were to be halved as seems very likely
  • The notable holding level target reduction was in specialist investment Assura plc, the niche healthcare property vehicle; it had performed extremely well in 2015 and the yield had fallen to 4%, a level we considered unattractive in comparison with our other REITs
  • It is encouraging to note that the timing of our addition of Halfords to the target portfolios at the very end of November was very opportune; the stock is now trading above our average purchase price which given the performance of equity markets is an excellent result; early days yet of course but it is always nice to get the timing as well as the long term right

 


Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 31.01.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.
Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP16/23.

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Peter Elston’s Investment Letter – Issue 9 January 2016

5 January 2016

Executive summary:
  • We believe on balance that the world will continue to grow in 2016, that equity market valuations by and large are low enough to make positive returns likely, and that western government bonds remain overvalued.
  • The US and China contributed 82% of global nominal growth over 2014 – 2015, and so our review for 2016 starts with these two major economies:
  • Economic data coming out of China, following the prolonged period of excessive bank lending to capital projects (money supply is off the scale), is contradictory. This said, there are signs of progress in the services sector, in the anti-corruption drive and in reforms to the welfare system. Overall, our view is that China as a command economy is advantaged in the shift it is trying to make to more services/consumption driven growth.
  • The tapering of QE implies that real US rates have already risen substantially. With the process of modest rate rises now underway and likely to continue, albeit haltingly and only to what will remain historically low levels, the future shape of the economic cycle has become more difficult to determine. This said, the US yield curve is not suggesting recession whilst the fall in unemployment has been flattered by those who have temporarily (?) left the labour market. We don’t believe the cycle is at an end yet.
  • Elsewhere in Asia, Japan continues to face massive demographic headwinds, however the ‘three arrow’ reforms are providing opportunities for some companies to move ahead of their competitors, and there is plenty of scope for bottom up stock selection.
  • In mainland Europe, QE has a long way to go which is likely to be supportive of growth and this is our largest overweight position in equity markets. Meanwhile, in the UK, inflationary pressure remains benign, and the yield curve supports the view that growth can be maintained for now.
  • In terms of valuations, whilst our zero position in developed sovereign bonds is not helping us substantially yet, at some stage, we believe yields will rise significantly and government bonds will bite the hand that bought them. We see no value.
  • High yield bond spreads have moved out, which given our expectation of future growth means this is an attractive area for us, though we continue to avoid the oil and gas industry, which is suffering from the Saudi squeeze on margins.
  • With regard to equities, these appear reasonably valued especially on price to book and yield metrics, and the apparent lack of any imminent end to the global cycle from yield curves and labour markets.
  • Within the equity arena, in addition to Europe, we particularly highlight the value in UK mid-caps, where we expect continued good performance, and which are free from the excessive dividend concentration and low dividend covers so apparent in the large cap universe.

 


2016 investment outlook

This investment outlook is particularly hard to write. The world’s two largest economies, the US and China, are at critical junctures. While, the US is arguably much closer to the end of its business cycle than the beginning, as evidenced by unemployment that has been falling for six years and that has just recently hit 5%, China is undergoing a pronounced and persistent structural slowdown, as evidenced by plummeting industrial metals, iron ore and bulk shipping prices. Throw in the conundrum of low or negative real long-term interest rates, bloated central bank balance sheets, widespread wealth and income inequality, the impact on growth and inflation of the internet, the shift away from fossil fuels, aging populations, financial sectors in the developed world that remain huge and complex, and over-indebted private sectors, and you have an investment strategist’s nightmare – how on earth to make sense of everything?

My framework for thinking about markets and asset classes has a medium-term element and a long-term element. The former is based around the business cycle while the latter attempts to assess the aforementioned structural trends in order to form an opinion as to whether the world economy will grow or stagnate over the longer term (I think it will grow).

With respect to the business cycle I try to keep things simple, looking ostensibly at the unemployment rate in a particular country. This works better in developed countries where cyclical rather than structural forces dominate. In the US, for example, the unemployment rate has exhibited significant regularity over the last fifty or so years (chart 1).

Chart 1: US unemployment rate

Chart 1 - US unemployment rate

Source: Bloomberg

 

The yield curve also tends to be a good leading indicator of growth – all five recessions in the US since 1975 were preceded by an inverted yield curve and not once did an inverted yield curve not lead to a recession (chart 2).

Chart 2: US: yields curve versus Conference Board coincident index

Source: Bloomberg

 

Table 1: Annualised returns

* 6 month moving average of 10 years minus 2 years. Source: Bloomberg.

 

Correctly predicting recessions can help add substantial value to the performance of multi-asset funds from time to time (at business cycle extremes) given the strong link between recessions and inflation and thus bond market performance on the one hand and between recessions and corporate profits and thus equity market performance on the other. This is what our tactical
asset allocation framework at Seneca seeks to do.

 


 

One third of the global economy on a purchasing power parity basis is accounted for by the US and China. Furthermore, between them, they accounted for 82% of global nominal growth over 2014-5.

As far as the overall world economy is concerned, it still appears to be operating below capacity, as can be seen in chart 3. Although the IMF output gap for advanced economies has risen since the crisis as should be expected, it is still -2%. This suggests there remains considerable scope for the global economy to recover and we are thus some way off from the point at which central banks will need to consider restraining growth rather than supporting it.

Chart 3: IMF output gap

Chart 3 - IMF output gap

Source: Bloomberg

 


United States

Employment in the US has been rising now for the best part of six years. The previous three expansions saw employment rise on average for 6 years, so on the face of it, it appears we should be nearing the end of the current expansion. The unemployment rate has fallen to 5%, which compares to trough rates during the last three cycles of 5%, 4% and 4.5%. Surely the current expansion is running out of steam?

Perhaps not.

If one looks in more detail at the employment data, one can reach a different conclusion. The number of employed as a percentage of the working age population has indeed been rising but not by much. During the global financial crisis, the percentage fell from 63.0% in June 2007 to 58.3% in December 2009. In the years since, it has retraced just 21% of the previous decline, and currently stands at 59.3%. And yet the unemployment rate has fallen all the way back to 5%, retracing 90% of its previous increase.

The explanation lies in the fact that the workforce as a percentage of the working age population (known as the participation rate) has been declining sharply (see chart 4). Some of this decline is due to demographic factors such as the aging population but not all of it. Many left the workforce because they gave up looking for work. What this means is that the economy in the US can continue to improve without putting upward pressure on wages, as supply of labour is boosted by people rejoining the workforce. This means that inflationary pressures should remain benign for some time, allowing the Fed to maintain an accommodative monetary policy – interest rates may rise but they will almost certainly remain low.

Chart 4: As percentage civilian non-institutional working age population

Chart 4 - Percentage civilian non-inst working age population US

Source: Bloomberg

 

That said, there is no doubt that some parts of the US economy are struggling at the moment. The strong dollar has put pressure on manufacturers while the sharp decline in the oil price has led to a contraction in the oil and gas sector. The question is whether weakness in these areas of the economy will cause weakness more broadly.

I think not.

America’s economy is big enough, deep enough and strong enough to absorb the pain. It should be remembered that services account for 80% of the US economy. If anything, contractions in manufacturing and energy sectors should be considered part of the process of creative destruction, with freed up labour getting employed in other, higher value-added areas of the economy.

This optimism, at least as far as the economy is concerned, is supported by yield curve data. As can be seen in chart 2, although the yield curve has fallen over the last 5 years, it is still well above zero, standing currently at 1.2% (recall that the yield curve falling below zero tends to indicate that a recession is not far off). During the last two cycles, it took 6 years and 2 years respectively for the yield curve to fall from 1.2% to below zero, suggesting that the next recession is some way off.

Of course there are other factors that complicate the picture. It is possible that with interest rates close to or at the zero bound, the yield curve is less useful as a recession predictor. Furthermore, the tapering of asset purchases by the Fed constituted a de facto tightening of monetary policy, so while we have only just seen the first increase of the Fed Funds rate, this hides the fact that monetary conditions have been on a tightening path for some time. This is illustrated in the chart below, which shows the actual Fed Funds rates along with what is known as Krippner’s shadow rate. Leo Krippner is a member of the research team at the Reserve Bank of New Zealand and he devised a method using:

“bond option pricing techniques to formally model the value of the option for investors to hold physical currency at the ZLB (zero lower bound). That enables an estimated “ZLB/currency option effect” to be removed from the observed yield curve data, leaving the “shadow yield curve”; i.e. a hypothetical yield curve that would exist if physical currency was not available.”

I don’t understand it either, but conceptually one should be able to grasp the idea that it must be possible to measure the effect of quantitative easing in terms of an effective interest rate below zero. Looking at chart 5, one can see that the effect of QE from 2008 to 2012 was to take the effective short term interest rate from zero to around -6% (note that this is a rate that cannot be observed, only felt). The tapering of asset purchases that was announced in the middle of 2013 has seen the shadow rate rise back to close to zero, and it is thus entirely logical that this is the point at which the Fed would raise the actual Fed Funds target rate.

The point is that if one uses the shadow rate rather than the actual rate, we have already seen a rise in short term rates similar to that seen from 2004 to 2006 that arguably precipitated the fall in the housing market and in turn the GFC.

As it happens, I don’t think we are very close to the end of the tightening cycle, for the reasons mentioned earlier with respect to the labour market, but I would imagine the end of QE makes things less predictable than would otherwise be the case.

Chart 5: As percentage civilian non-institutional working age population

Chart 5 - Krippner's shadow rate vs actual Fed funds rate

Source: Bloomberg, Reserve Bank of New Zealand
(http://www.rbnz.gov.nz/research_and_publications/research_programme/additional_research/monthly-update-dec-2015.xls)

 


China

While it is pretty clear that the fall in the oil price has been supply driven, with the Saudis playing a high stakes game of trying to drive out higher cost producers by turning on the taps, it seems the fall in industrial metals and iron ore prices is demand driven, with China principally to blame.

It is now well understood that China is in a transition phase, as its one dimensional growth model based around building stuff financed with bank credit reaches its limits. What it transitions to and how smoothly it does it are still unclear, but the shift has certainly caused a lot of pain in commodity producing countries such as Australia, South Africa and Canada.

The strengthening of the US dollar has not helped matters, given the renminbi’s link to the greenback, and while headline GDP growth is still a very respectable 6.9%, there are suggestions that things could be much worse – how I wonder can electricity consumption be growing only at 0.6% year on year if the economy is growing at close to 7%? The fact is that it is very hard to get a good understanding of what is going on in China. For a country with GDP per capita of just over $8,000, China’s money supply is off the scale (see chart 6).

Chart 6: Money supply as percentage of GDP versus GDP/capita

Chart 6 - Money supply as percentage of GDP versus GDP-capita China

Source: Bloomberg

 

View from the Bund, early 1990’s               View from the Bund, 2010

The Bund, early 1990's & 2010

Source: Skyscrapercity.com

 

Although China’s shift away from manufacturing is evident in manufacturing PMIs that have been hovering around 50 for some time – a level that indicates neither expansion nor contraction, services PMIs have remained well above 50, though admittedly have been on the decline (chart 7).

Chart 7: China purchasing manager indices (PMIs)

Chart 7 - China purchasing manager indices (PMIs)

Source: Bloomberg

 

Aside from the shift away from steel and concrete towards services and consumption, there are other important changes afoot in China. The collapse of Macau casino revenues is an indication that president Xi’s anti-corruption drive is biting, while reforms of China’s welfare system are ongoing, a good example of which is allowing migrant workers access to education and healthcare. While it remains to be seen whether China can make this transition smoothly, I suspect such change is more easily achieved in a command economy like China’s.

 


Europe and Japan

The two developed countries and regions where growth has been most elusive are Europe and Japan. As can be seen in chart 8, growth in Japan and Europe has been noticeably lower than in the US and UK. In Japan’s case this is because of severe demographic headwinds. The government forecasts that the country’s population will fall from around 128 million currently to 86.7 million in 2060 (figure 1). Furthermore, the number of people aged 20-64 is expected to fall from 75 million to 41 million over the same period. With market shrinkage on this scale it is no wonder than Japanese corporate investment is so weak. Indeed this severe structural headwind is what is behind (or in front of!) prime minister Shinzo Abe’s so-called ‘three arrow’ reforms. Indeed, while the long-term outlook for Japan’s growth is not so good, the reforms are providing opportunities for the more innovative and nimble companies to get ahead of the more sleepy incumbents. Japan may not be interesting from a top-down perspective but that does not mean there are not interesting bottom-up opportunities.

Chart 8: Economic growth (incl. forecasts) in key developed countries and regions

Source: Bloomberg

 

Figure 1: Japan’s population

Figure 1 - Japan's population

Source: http://www.ipss.go.jp/s-info/e/ssj2014/images/001_01.jpg

 

Europe’s problems have also been structural but not demographic. Growth prospects have been weighed down by politics and the lack of reform with respect to the region’s banks, as well as high interest rates in Europe’s periphery. Nevertheless, recovery is now firmly in place, if some way behind the likes of the US and the UK. 10 year yields in the periphery on average are now close to 3% (chart 9) while employment conditions across the region are steadily improving (chart 10). Though the unemployment rate has fallen from just over 12% in 2013 to 10.7% currently, it is still high and still far above the pre-crisis low of 7.2%. This means one thing: monetary policy will remain very loose for some time to come.

Chart 9: Europe 10 year government bond yields

Source: Bloomberg

 

Chart 10: Unemployment rates in Europe and US

Source: Bloomberg

 


United Kingdom

As can be seen in chart 8, the UK’s economic performance has almost been on a par with that in the US. Growth since 2010 has averaged 2.1%. While this is lower than pre crisis growth of around 3%, it is nonetheless better than growth across the channel or in Japan. Bank of England governor Carney has conceded defeat to his adversary (or is it colleague?) across the pond in the race to be the first to raise interest rates, and it now seems that a rate rise in early 2016 is off the table. Inflationary pressures remain benign: although core inflation has been rising, at 1.2% year on year it is still well below the central bank’s 2% target.

As for the yield curve, it has fallen from the 3% post crisis level but is still steep at just over 1%, suggesting that growth momentum can be maintained for the foreseeable future (chart 11).

Chart 11: UK: yield curve versus coincident index

Source: Bloomberg

 


Asset class and market views
Government bonds

There is very little if any long-term value in developed government long bonds, with real yields either very low or negative (chart 12). However, this does not mean that in the short term they cannot perform well, before the long-awaited bond bear market finally begins. The trigger for good performance over the next year or two would be widespread global recession that would cause inflation to fall and real yields to fall even further. However, I do not think this scenario likely, given that monetary policy across the developed world remains very stimulative. While the plunging oil price is no doubt causing a great deal of pain among higher cost producing companies and countries, on balance I think it is a net positive for the global economy. With inflation, real yields and credit risk all at very low levels, and governments and their central banks providing a great deal of support, the risks would appear to be on the upside (for yields).

Chart 12: Inflation linked bond yields

Source: Bloomberg

 

In sum, we continue to steer clear of developed sovereign bonds, though accept it may be a little while yet before this position really starts to work for us. That said, one can clearly see that there has already been a change in trend with respect to the performance of government bonds (chart 13). Pre-crisis, the DB Global Government GBP Hedged bond index in real terms was generating trend returns of around 4% per annum. Since 2009 however, this trend rate has fallen to 0.8% per annum. The drag of an underweight position is falling considerably.

Chart 13: Global government bonds

Source: Bloomberg

 


High yield bonds

As can be seen in chart 14, high yield bond spreads had been nudging up since the first half of 2014, before rising sharply in recent weeks. Most of the pain has been felt in the US energy sector as a result of the strain being put on shale producers by the falling oil price. However, there has been some spillover, with yields in other sectors as well as in Europe also affected.

Given my view that the global economy will continue to grow this year, these higher spreads represent good buying opportunities, though we would continue to avoid the energy sector in view of the fact that the Saudis are unlikely to capitulate with respect to oil supply.

Chart 14: High yield spreads

Source: Bloomberg

 


Equities

On the face of it, there appears to be a rather worrying decline in corporate profitability as measured by return on equity (chart 15). However, dig a little further and one finds the decline is concentrated largely in one sector: energy. Over the last four years the return on equity of the MSCI World Energy sector index has fallen from 17% to -3% (this helps explains why the oil and mining heavy FTSE 100 index has been such a poor performer this year). As can be seen in chart 16, the profitability of the consumer staple sector has been pretty stable in the 17-20% range.

Chart 15: Global corporate profitability

Source: Bloomberg

 

Chart 16: Corporate profitability by sector

Source: Bloomberg

 

As for global equity valuations, they remain very reasonable, and indeed have become even more reasonable in recent weeks. On both a price-to-book and dividend yield basis, the MSCI World index is on the cheap side relative to history. Sure, valuations are well above where they were at the depths of the crisis, but they are still below historic averages (chart 17).

Chart 17: Global equity valuations

Source: Bloomberg

 

As far as dividend streams are concerned, there are no obvious signs that they are overstretched. In the US, dividends per share have been growing at a decent pace since 2010, and indeed as can be seen in chart 18 have been keeping pace with the index (or is it the other way round?!) It should also be noted that over the last 50 or so years, dividends in the US fell only during the more recent bear market, and even then the falls were concentrated in one sector: financials.

Chart 18: US equities and dividend distributions

Source: Bloomberg

 

As for the UK, dividends have also been growing at a reasonable pace since 2010 and if anything, as can be seen in chart 19, have been outpacing the advances in the market (dividend yields have risen).

Chart 19: UK equities and dividend ditributions

Source: Bloomberg

 

Perhaps the starkest illustration of the decent value that is now offered by UK equities, at least in relative terms, is how the equity dividend yield compares with the real long bond yield. While the equity market’s dividend yield has undulated in the 3-5% range over the last 20 or so years, the real long bond yield has fallen from 4% to -1% (chart 20). For those who argue that one should subtract the inflation rate from the dividend yield, recall that Gordon growth says that the future market nominal return is equal to the dividend yield plus nominal dividend growth. The future real return is the dividend yield plus real dividend growth. In other words, inflation gets subtracted from the growth part not the yield part.

Chart 20: UK equity and bond yields

Source: Bloomberg

 

Finally, a mention of UK mid-caps (the UK equity portions of our multi-asset funds have a strong midcap bias). As can be seen in chart 21, midcaps in the UK have performed extremely well in relation to their large cap peers over the last two decades (the margin is around 4% per annum). Given the prospects of continued accommodative monetary policy and an economy that continues to improve, the prospects for midcaps remain decent. Indeed we think that our funds’ exposure to midcaps is one of our key differentiating factors. Not only would we expect midcaps to continue to outperform large caps over the longer term, but the subsector also provides better stock picking opportunities, given the thinner research coverage.

Chart 21: UK mid cap performance (relative to UK large caps)

Source: Bloomberg

 

Wishing everyone all the very best for the year ahead!

 

 


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Important Information

Past performance is not a guide to future returns. The information in this document is as at 30.11.2015 unless otherwise stated.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
Seneca Investment Managers Limited (0151 906 2450) is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/170.

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Peter Elston’s Investment Letter – Issue 8 December 2015

15 December 2015

As we approach Christmas, this month’s letter will be a little shorter and thus I hope easier to digest, at least than the average Christmas feast! Furthermore, since January’s letter will include my market outlook for 2016, I thought that this issue should look back at 2015, particularly with respect to how our three public funds have performed. Of course the year is not over yet and anything (or nothing!) can still happen in the weeks remaining, but at least as far as our peer group standings are concerned there should not be much change between now and the end of the month.

A review of 2015

In what was a fairly trendless and thus tricky year for markets, our three funds performed well in both absolute terms and relative to their respective peer groups in the calendar year to 4 December. Given our strategic asset allocations, our expected long term real returns for each asset class, our fund costs and the value added we expect to generate from tactical asset allocation, stock selection and fund selection, we would hope over the longer term to achieve a real return of around 5% per annum for the CF Seneca Diversified Income Fund and 6% for both the CF Seneca Diversified Growth Fund and Seneca Global Income & Growth Trust.

In the 49 weeks so far, we have achieved, in nominal terms, 4.9%, 5.6% and 7.2% for the income fund, the growth fund and the trust respectively. Given that the UK consumer price index rose just 0.2% in the ten months to October, this means that the performance of our funds in real terms has either been very close to or exceeded our long-term return expectations.
Furthermore, the three funds have performed considerably better than their respective peer group average (see table 1 over the page).

It should be noted that in the case of the investment trust and its peer group, the performance and volatility numbers are based on total shareholder return, a measure of net asset value including dividends rather than share price including dividends. Also, the volatility number is the volatility of daily total returns which is then annualised. Finally, I have also included for comparison purposes four other IA sectors that may include multi-asset funds and thus which should be considered relevant.

Table 1: Total return and volatility statistics

Table 1 - Total return and volatility statistics

Source: Bloomberg

What is also pleasing is that our funds’ volatility has been considerably lower than that of the respective peer group.

The primary reason for our good performance has been our exposure to UK mid-caps. All our funds invest directly in the UK, which not only helps to keep our costs down but by focussing on the mid-cap space exposes us to better idiosyncratic and systematic returns than would be the case with large-caps. Research coverage is thinner among mid-caps so the opportunities to find under-valued situations are more prevalent. Furthermore, we would expect mid-caps to continue to outperform large caps over time – since March 1995, mid-caps have outperformed large-caps by 131% (4.1% per annum) and have outperformed in 72% of rolling 12 month periods.

Within overseas equities our biggest tactical position is a 5 percentage point overweight (in all three funds) in Europe ex UK which was worked largely because the majority of the exposure has been in currency hedged funds. At the end of 2014 we felt that the likely direction of monetary policy would be positive for equity markets but negative for the Euro which indeed has been the case.
As for fixed interest, we maintained our zero position in G7 government bonds. This position detracted in 2014 but has started to work in 2015. The DB Global Government Hedged GBP index has returned 1.4% this year and although this is still the right side of zero, it is less than previous years and also less than other areas of the fixed interest market we have been exposed to such as high yield.

Our fourth asset class is what we call ‘specialists’ where we invest in specialist funds such as renewable energy, asset leasing, REITs, private equity, loans and reinsurance (note that we do not invest in hedge funds, structured products or tangible assets such as precious metals, art, coins and stamps). Our REITs have performed particularly well this year, with Assura, GCP Student Living, LondonMetric and Tritax Big Box all posting double digit returns. We think ‘specialists’, which is well represented in all our funds’ strategic asset allocations, is an area that will continue to enhance both the return and risk characteristics of our funds.

Finally, as a result of the good performance in 2015, our 3 and 5-year quartile rankings have improved. These are of course the periods on which we should ultimately be judged (see table 2 below).

Table 2: Annualised returns

Table 2 - Annualised returns

Source: Morningstar

 


Inflation watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

Inflation data releases over past month

Inflation data releases over past month

Source: Bloomberg

What is particularly notable about the table above is that inflation almost everywhere is lower than desired. The only place where inflation is close to where the central bank would like it is the US, where CPI ex Food & Energy is running at 1.9%. Even so, other measures in the US are weak. For example, the PPI ex Food and Energy index at the end of October was only 0.1% higher than a year earlier.

It is also notable that in general, inflation data around the world are still coming in lower than expected and also lower than the previous month. In such an environment one would have thought that despite the talk to the contrary there is still a decent chance that the Fed will hold off raising rates at its December meeting.

 


Employment watch

Most if not all central banks are tasked with maintaining price stability and full employment. This section looks at recent employment trends and what they might mean for monetary policy around the world.

Employment data releases over past month

Employment data releases over past month

Source: Bloomberg

Unemployment continued to fall across the developed world but in all cases remains about what should be considered full employment. I am reassured by these trends. If we started to see unemployment rising across the globe, this would be indicative of economic growth stalling and perhaps the proverbial ‘canary in the coalmine’ with respect to a looming global recession. Employment conditions continuing to improve with inflation pressures remaining benign or weak should be conducive for equity markets.

 


Captain Murphy’s diary

Murphy’s Law says that what can go wrong, will go wrong. It is thought to be named after Captain Ed Murphy, an aircraft engineer who, frustrated with the work of an incompetent colleague, is alleged to have remarked, “If there is any way to do it wrong, he will.” This section is dedicated to combing the financial markets for risks that are lurking out there, preparing to pounce.

 

I’ve always enjoyed reading Financial Times columnist Martin Wolf’s articles. His approach to economics often focusses on the balance between savings and investment and how that balance helps explain such things as growth and the level of interest rates. If there are more companies and individuals who want to save than want to invest then it follows that real interest rates must fall to a level that encourages more investment and less saving.

Wolf’s latest piece (Corporate surpluses are contributing to the savings glut, November 17th) is about the excess of savings in corporate sectors around the world – particularly those in developed countries – and how this is impacting interest rates and growth. Wolf points out that the imbalance is as much about a lack of investment as it is about too much saving. Is this imbalance temporary or is it structural and thus perhaps something to be more deeply concerned about?

Oscar Wilde said that “people who live within their means lack imagination”. I doubt that he meant it in relation to economic systems but nevertheless its relevance in this regard is rather neat. The fact is that if everyone on the planet wanted to live within their means the global economy would collapse. Economic growth relies on people or businesses who are prepared to take risks and spend more than they earn. If you want to live within your means – meaning that you want to spend less than you earn – there needs to be someone else doing the opposite. It is a mathematical identity or truism that in aggregate spending must equal income, savings must equal investment. Those who live beyond their means (borrowing to fund ideas and dreams) should be applauded; it is their risk taking that drives growth.

As to why corporate investment is weak, Wolf puts forward three reasons. First, demographics; if societies are aging and population growth falling, there is less need for corporate investment to grow capacity. Second, globalisation has meant relocation of investment from high-income developed countries to lower-income developing countries. And third, technological innovation. As Wolf points out, “much innovation seems to reduce the need for capital: consider the substitution of warehouses for retail stores”.

I wonder if the internet isn’t almost single-handedly to blame. True, computers changed our lives, but for me it is the internet that has transformed them. It has been a hugely deflationary force, with high street shops being replaced with online shops and people now able to organise things themselves rather than having to engage and thus pay an intermediary, travel being a good example.

Will the global economy find ways to employ the excess capital and labour that now exists? Almost certainly. It has for the last several thousand years without too much trouble. It’s just it’s never had to do it this quickly.

 


Current fund targets as at 7th Dec (previous month’s targets in brackets)

The targets in the table below are where our funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Current fund targets 7th Dec 2015

 

  • Very little change to tactical asset allocation in November.
  • SIGT’s total equity target was increased to 62% to bring the trust in line with the two OEICs i.e. 2 percentage point overweight.
  • This was effected through an increase in UK equity target from 28% to 30% which also brings the trust more in line with the two OEICs in terms of the position relative to strategic asset allocation.
  • At a holding level in the UK we added Senior plc to both the growth fund and SIGT. The company is a “build-to-print” manufacturer of high technology components and systems for original equipment producers, principally in aerospace, defence, land vehicles and energy markets. The stock offers a 2.8% dividend yield for CY2015 which is 3.1 times covered. Return on equity is a respectable 18%.
  • In Japan we added the Coupland Cardiff Japan Income & Growth Trust to all three funds – this is an IPO and a closed ended version of Coupland Cardiff’s successful open ended version. We like the value oriented approach of the manager and the fact that the trust is hoping to achieve a 3% yield, unusual for a Japanese equity fund.
  • In the growth fund we reduced the holding in iShares Gold Producers ETF. This followed it being reclassified from ‘specialists’ to ‘overseas equities’ as well as a more general move away from passives on our part.
  • In ‘specialists’ we reduced the target weight in Tritax Big Box. The distribution and logistics property specialist has performed extremely well and as a result its yield has fallen to the point where better opportunities exist elsewhere in the REITs sector.
  • As far as broad asset class views are concerned there has been little if any change.
  • Equity market yields generally remain above their historical averages and thus offer reasonable value.
  • Within fixed interest, developed market sovereigns remain overvalued, with real yields that are either low or negative.
  • Both the above views are predicated on the belief that monetary and fiscal policies in large or developed countries will continue to prevent economies from slipping into recession. Recession on a global scale would of course be negative for equities and positive for save haven bonds.

 


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Important Information

Past performance is not a guide to future returns. The information in this document is as at 30.11.2015 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.

The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).

Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/161.

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Peter Elston’s Investment Letter – Issue 7 November 2015

9 November 2015

We may yet be proved wrong but it is starting to look as if our call that we were not heading into a more pronounced period of equity market weakness was a decent one. In a yourmoney.com article on 2 October, I was quoted as saying that most bear markets begin when economies are strong or overheating. As evidence, I pointed to the IMF world output gap having been 2% in both 2000 and 2007 when the last two bear markets began, whereas the gap currently is -2%. I also noted, though it wasn’t used in the article, that bear markets also normally begin when markets are overvalued, again pointing to high valuations in 2000 and 2007, and current valuations that are certainly not stretched (in fact dividend yields pretty much everywhere are above their longer term averages).

I stand by these assertions.

There is no doubt that it is very hard being an investor at the moment, let alone being an asset allocator. Negative real interest rates, bloated central bank balance sheets, a slowdown in China, weak investment across the developed world all serve to cause consternation that another 2008 is just around the corner. My view is that ultra-loose monetary policy and scope to boost fiscal policy if required will prevent growth from slipping into recession. Furthermore, the prevailing weakness will keep a lid on inflation. This is a ‘Goldilocks’ environment that equities tend to thrive on.

Contrarian opportunities

Thanks to Canaccord’s Alan Brierley for his slides highlighting some interesting contrarian opportunities. The four he presented were MSCI World Value (having underperformed MSCI World Growth), MSCI World ex US (versus S&P Composite), MSCI Emerging Markets (versus MSCI World) and Euromoney Global Mining (versus MSCI AC World). The four had underperformed their respective comparator by 19, 39, 43 and 73% respectively in recent years.

What do we think about these opportunities?

As multi-asset value investors, we’d certainly support the assertion that value will do well, though it is hard to know when it will start outperforming growth. Since inception of the indices in November 1975, the MSCI World Value index has returned 7.4% per annum versus Growth’s 6.8%. This may not sound like much until one realises that over the 40 years, Value’s total excess return equates to a very decent 22%.

As for the MSCI World ex US in relation the S&P Composite, we’d also agree that the US will start to underperform (in our Income Fund we have zero exposure to US equities given paucity of yield). The US market is starting to look obviously expensive versus the rest of the world: the price to book ratio of the MSCI US index is 2.8 times versus 1.6 times for the World ex US index. While US companies may be more dynamic than those elsewhere, we think the valuation gap is too big. Furthermore, it is clear that the US is closer to its business cycle peak that other developed countries, notably Japan and many in Europe, so monetary policy tightening is also closer.

The emerging markets versus developed markets question is a particularly intriguing one. I have for a long time held the view that emerging markets are horrible places to invest. The ‘region’ is stuffed full of corrupt countries and poorly-governed companies, and as a result the stronger economic growth achieved has not filtered down to shareholders. Since inception of the index in 1987, the MSCI Emerging Markets index has returned 7.7% per annum. This compares with 7.8% for the MSCI US index, pretty poor when you consider the difference in economic growth. Furthermore, when you take volatility into account, you’d wonder why anyone would invest in emerging markets: 29% versus 17% for the US. Having said all that, the current price to book ratio of the MSCI EM index of 1.4 times is getting close to the 1.2 times it reached at depths of the global financial crisis. We’re still underweight emerging market equities but are starting to think there is value emerging.

Finally, what about global miners? Well, in August we made a move into Blackrock World Mining Trust, feeling that the 10% yield that was on offer was good value even if dividends were halved. So we’d agree with Alan on that one too.

 


Inflation watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

The table below lists price data releases over the last month in various key countries and how they compare with the survey consensus, the previous month, and where central banks would like the rate to be (the last of these requires a bit of judgment). It also derives an average of the comparisons by taking the net number of up and down arrows and dividing by the number of data releases.

Inflation Watch Table

Source: Bloomberg

Overall, inflation pressures in the developed world and in key emerging markets remain very weak. This means that monetary policy will remain loose for some time to come which should be positive for equity markets and other so-called ‘risky assets’.

Overall, inflation data is coming in slightly below expectations but slightly above prior periods. The big discrepancy is between current rates of inflation and desirable rates of inflation – in most countries other than the US, inflation is much lower than central banks would like.

 


Employment watch

Most if not all central banks are tasked with maintaining price stability and full employment. This section looks at recent employment trends and what they might mean for monetary policy around the world.

Employment Watch Table

Source: Bloomberg

Unsurprisingly, given the weak inflation pressures, unemployment rates around the world are still in general above the level that central banks would consider full employment. Furthermore, while the rate in the US may be getting quite close to the NAIRU (non-accelerating inflation rate of unemployment), it should be remembered that many have left the workforce over the last few years. A better job market may tempt them back in the coming months and years, thus keeping wage pressures lower than would otherwise be the case.

 


Captain Murphy’s diary

Murphy’s Law says that what can go wrong, will go wrong. It is thought to be named after Captain Ed Murphy, an aircraft engineer who, frustrated with the work of an incompetent colleague, is alleged to have remarked, “If there is any way to do it wrong, he will.” This section is dedicated to combing the financial markets for risks that are lurking out there, preparing to pounce.

Question: is China a slow motion train wreck or has the Communist Party found the secret to generating high and stable growth?

China has the potential to cause global markets serious problems. Its economy is huge and has been growing at a relentless pace for a number of years. Furthermore, its growth has been one-dimensional, based on building and making ‘stuff’ using bank credit. This is evident from the below two charts.

The first chart illustrates the extent to which China has consumed vastly more cement per person per year than any other country on the planet, particularly when GDP/capita is taken into account. Even Bill Gates was moved to tweet a few months ago about what he thought was the most mind-blowing fact he had learned in 2014, namely that China used more cement in the three years from 2011 to 2013 than the US used in the entire 20th century (6.6 gigatons versus 4.5 gigatons).

The second chart shows the extent to which China’s use of bank credit is also off the scale in relation to its GDP/capita. Given the best fit line, China’s money supply as a % of GDP should be 125% given its GDP per capita of $8,280. In fact, it’s 208%.

Cement consumption per capita vs. 2012 GDP per capita

Cement Graph 1

Source: Deutsche Bank (2014)

Money supply as % GDP vs. GDP/Capita

Cement Graph 2

Source: Deutsche Bank (2014)

What these observations mean for China’s future growth prospects is very hard to say. China has far too much cement capacity and the same goes for other commodities too, steel being a good example. Shutting much of the capacity (an inevitability) would be deeply painful for banks and employees alike, but perhaps not terminal. Laid off employees would eventually be rehired in more value added activities and the banks would be recapitalised as they have been in the past. The problem is that the numbers are so far off the scale that there is no precedent, and no precedent means a lack of predictability.

Another measure on which China scores highly is average GDP growth adjusted for the volatility of GDP growth (think of it like a Sharpe Ratio for economies, the higher the better). As can be seen in the table below, China has achieved high and stable growth. The only country that comes close is India, with an “Economic Sharpe” of 3.1 times versus China’s 4.6. Perhaps it has been learning a few tricks from its bigger emerging cousin. Whether these are accounting tricks or some sort of growth miracle is of course the big question.

Captain Murphy Table

Source: Bloomberg

 


Current fund targets as at 2nd Nov (previous month’s targets in brackets)

The targets in the table below are where our funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Current fund targets

  • We increased the equities weighting in the OEICs by 1 percentage point each in October, taking them to 2 percentage points overweights relative to the respective strategic asset allocation
  • We did this predominantly because we felt markets were looking slightly cheap, with dividend yields generally above long-term averages
  • We also think that monetary policy will remain on the whole loose, with inflation pressures still muted in many countries
  • We did not increase the equity weight for the investment trust, which because of its closed-end structure has a higher weighting in less liquid specialists
  • The aforementioned 1 percentage point increases in equities targets came out of fixed interest in the Income Fund (reduction in corporate bonds target) and specialists in the Growth Fund (Exit from Woodford Patient Capital which was only held in the Growth Fund)
  • We continue to avoid developed market government bonds which we still think are very overvalued
  • Within fixed interest, we have a focus on global high yield; this segment of the fixed interest market was hurt along with equities during the August sell off but we held firm in the belief that while spreads were lower than they were five or so years ago, they were still well above historic lows and thus offered good value
  • We retain exposure to emerging market local currency debt in the OEICs but have not increased it; frankly, we had not expected the selloff that we have seen this year in emerging market currencies
  • Our specialists exposure seeks to target investments that offer something interesting in relation to equities and bonds; in the case of equities this is more stable income streams and in the case of bonds it is income streams that are index-linked
  • Our private equity exposure in each of the three funds is largely in AJ Bell, a private company in which we are one of three outside shareholders
  • Elsewhere in specialists, we like non-core REITs, asset leasing and renewable energy

 


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Important Information

Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.

The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

CF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you should read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).

Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/138.

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