Allianz UK Opportunities - UK Domestics - a phoenix from the ashes? - Allianz Global Investors
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Allianz UK
Opportunities
UK Domestics – a phoenix
from the ashes?
For professional investors only Q1 2018
In a longer report on UK equities, Matthew Tillett, manager of the Allianz UK Opportunities
Fund, looks at the UK domestic debate: the myths and realities, the opportunities and risks. What is
driving UK domestic share prices, their valuations, and what the Fund has been doing as a result
Matthew Tillett, Portfolio Manager
D uring 2017 the Allianz UK Opportunities Fund returned a
respectable 15.5% net of fees and expenses, ahead of the
FTSE All Share 13.1% total return. It was certainly an eventful year
FTSE 350 ex Investment Trusts (Trailing PE)
for UK investors. There was a surprise general election with an
even more surprising result, plus a number of mildly concerning
geo-political developments for investors to worry about –
although clearly not enough to stop the markets continuing their
bull run with remarkably low volatility.
What is most interesting to me is that despite the apparently
calm market environment at the index level, there has actually
been an unusually high level of sector and stock specific
Source: Exane BNP Paribas estimates.
divergence. This has been (and still is) a very momentum driven
market. There seems no limit to the valuation multiples the stock As a contrarian value driven investor, I love this sort of
market is prepared to ascribe to companies that are in sexy environment because invariably there are opportunities within
sectors such as technology. Meanwhile other areas that are out of those stocks that are deeply out of favour. Here I want to hone in
favour seem even more depressed than usual. Indeed the FTSE on one area in particular: UK domestic stocks, and specifically the
350 currently has the highest number of stocks with valuations in consumer facing companies.
excess of 20x p/e that it has ever had in its history. Yet it also has a
many stocks with p/e ratios below 10x, at least as many as its long
Undervaluing the domestic consumer?
run average. This is an unusual situation, and arguably not a This is a group that, with a few notable exceptions, has
particularly healthy one. It suggests a lack of market breadth with performed poorly since the EU Referendum vote. Over this
investors chasing momentum stocks ever higher at the expense period, the Fund has been increasing its exposure to UK domestic
those that are out of favour. stocks through the addition of a number of new holdings, many
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Allianz UK Opportunities
of which have some degree of consumer exposure. The shape of of them are operating in a much smaller market than their
the Fund has changed quite materially as a result of this. Prior to international peers. For me, as someone who is completely
the EU Referendum vote, the Fund had a very low exposure to UK agnostic to the composition of the benchmark, the domestically
domestic stocks (and virtually nothing in the consumer space), focused group of companies offer one of the largest hunting
whereas today this is one of the more significant exposures in the grounds investment ideas.
fund. So far this change has not added much in the way of alpha,
however looking forward I am optimistic that over the next few
Post-referendum depression
years these holdings can contribute significantly to the Fund’s There has been a lot of share price volatility amongst these
performance. companies since the surprise EU Referendum result in June 2016
as investors have downwardly reappraised their short- and long-
This report will explain the thinking behind this view. I will start by
term expectations for the UK economy. Sentiment has soured.
introducing the “UK domestic” universe, detailing the main
Most observers expect the economy to deteriorate or even fall
companies and sectors that make up this broad group. I’ll then
into recession. Moreover, many domestic companies, particularly
discuss the high level macro concerns that are depressing
those in the consumer sectors, are now under an ever darkening
valuations and why I believe these concerns to be misplaced.
structural cloud as Amazon and other online operators threaten
Honing in specifically on the consumer cyclical group – probably
to drive a truck through their business models.
the worst affected – I’ll show why I am still finding compelling
investment opportunities, although the outlook varies These are legitimate concerns. However, I believe the now
enormously by company and as a result it is important to have a widely-held bearish view is an over simplification of the reality.
robust framework to help identify the winners and avoid the For sure Brexit has created short term economic and political
losers. I will then cover each of the six investments the Fund has uncertainty and it is a logistical nightmare for all those tasked
within the domestic consumer cyclical group, concluding with with implementing it. But the long-term economic impact
some comments on what this means for the Fund’s overall remains to be seen. And yes there are plenty of domestic
positioning. consumer companies that will continue to struggle or die, but
there are also those that can survive and thrive in the Amazon
Domestic or domiciled? era. Valuation is the ultimate harbinger of long-term returns and
When I am asked my view on the prospects for the UK stock in this respect domestically focused companies have one big
market, I almost always begin my reply by pointing out that the thing going for them today: they are almost universally lowly
UK stock market is not the UK economy. Those of us who live and valued. Finding the long-term winners and investing in them at
breathe the UK stock market are well aware of this, but many low valuations has the potential to be very profitable, but to do
people I speak to are surprised to discover that domestically this requires first having a robust framework to identify who the
focused companies actually account for only a minority of the winners are.
overall stock market capitalisation. This is because so many of
the big “mega cap” companies – household names such as Shell,
Identifying the real domestics
Unilever, Glaxosmithkline and HSBC – are predominantly What does the domestic group look like once it is broken down
international businesses with very little domestic UK exposure. into its component parts? There are many ways to try and cut
Furthermore, most of these companies have, over the years, this. The approach I have taken is to include only companies that
become ever larger beasts as they have merged or acquired their derive at least 75% of their revenues from within the UK. This is
rivals in their bids for global dominance and scale. The top ten admittedly quite a tight criteria but it is still a significant number
companies in the FTSE All Share by market capitalisation account of companies. Apply it to the FTSE 350 and around 35% make the
for a whopping 42% of its overall market capitalisation and none cut. The breakdown is as follows.
of them are domestically focused1.
Consumer cyclical, 28%
However this observation does not negate the importance of
Financials, 19%
having an effective investment strategy for the domestically
Real estate, 16%
focused companies. They may be in a minority but it is Housing and housing related, 12%
nevertheless a significant minority. Most estimates I have seen Consumer staples, 8%
suggest somewhere between 25% and 30% of the FTSE All Share Utilities, 5%
by revenue is domestic. Remember also that the FTSE All Share is Commercial services, 4%
weighted by market capitalisation which means the larger the Telecommunications, 3%
company the more important it becomes within the index. If Transport, 3%
Construction, 2%
instead every company were given an equal weighting, a more
balanced picture emerges. This is because domestically focused
companies tend to be smaller in size, reflecting the fact that most
Source: Bloomberg, January 2018.
Allianz UK Opportunities
This is clearly a vastly different picture to the broader market, These valuation moves imply that market expectations for the
where sectors such as energy, mining, pharmaceuticals and domestic group of companies, and particularly the consumer
consumer staples dominate. It is also more cyclical. Consumer cyclicals, are very depressed. Why is this the case and is it justified
cyclical, which includes retail, leisure and entertainment, accounts by the facts on the ground?
for more than a quarter of the group. Housing and real estate are
also notoriously cyclical sectors. Financials is a diverse group that
Why are domestics so undervalued?
includes the highly cyclical domestic banks. At a macro level, I think there are three assertions that underpin the
current bearish narrative. Firstly, in the short term Brexit has created
How have domestics performed? an environment of economic and political uncertainty in which
Looking at share price performance reveals how starkly these businesses will delay or cancel investment spending while they
companies have underperformed over the past two years. In the await clarity on the final exit deal that the UK does (or doesn’t!) end
chart below you can see the share price performance of the FTSE up signing. The Government is weak without a majority, whilst the
350 index compared to “All domestics” (both in bold), with the opposition Labour party appears to making ground with its left-
latter having fallen by 6% whilst the former has risen nearly 20%. wing agenda. Consumer spending will also be under pressure in
This underperformance is all the more apparent when you this weaker economic environment, compounded by weak sterling
consider that the domestic group is included within the FTSE 350 which causes inflation to run ahead of wage growth. Secondly,
index itself, which implies non domestic companies have returned whatever the final Brexit agreement ends up being, it is very likely to
more that 20%. One important caveat here is the role of currency. be negative because there will be restrictions on access to all or part
Sterling has depreciated by 10% against the dollar and 16% against of the single market with the inevitable consequence that jobs and
the euro over this period2. This has obviously been a boon for the industry will move to the continent. This could well be a drag on the
earnings of the non domestic companies, but it is clearly not economy for many years to come. Finally, irrespective of Brexit, the
sufficient on its own to explain these divergent moves. UK economy is in a fragile state anyway. Both the consumer and
government are highly indebted, limiting the flexibility of the
Domestic UK share price performance versus FTSE 350 index
economy to respond to economic pressures.
Unpicking the Brexit effect
130
120
110
It is certainly not difficult to find purveyors of this narrative. The
100
90
economics profession seems more or less united that Brexit will be
80 bad for the economy. Most of the mainstream financial press such
70 as the Financial Times and the Economist seem vehemently anti-
60
Brexit. The Treasury famously predicted imminent recession if the
50
country voted leave. At times it can be difficult to extricate oneself
Oct 2016
Mar 2016
Oct 2017
May 2016
Mar 2017
Jun 2016
Jan 2016
Feb 2016
Aug 2016
Sep 2016
May 2017
Jun 2017
Apr 2016
Aug 2017
Sep 2017
Jul 2016
Nov 2016
Dec 2016
Jan 2017
Feb 2017
Apr 2017
Jul 2017
Nov 2017
Dec 2017
FTSE 350 Domestic banks
from this torrent of negativity, but staying objective in these
Domestic real estate All domestics situations is critical to successful long-term decision making. To my
Domestic consumer cyclical Domestic house building & housing related
mind, the economic situation is far more nuanced, and certainly
less bad than suggested by many of the bears.
Source: Bloomberg, AllianzGI estimates, January 2018.
It is important to remember - especially for those of us living in
It is also striking how dreadful the consumer cyclical group has
liberal-leaning London - that over half the country voted to the
been, languishing nearly 15% below the level of two years ago and
leave the EU. Many live in poorer parts of the country, they don’t
trailing the index in relative terms by over 35%. You might be
read the liberal press and have little interest in Westminster
thinking this reflects a deteriorating earnings profile in the wake of
politics. They are not unhappy about the Referendum result and
a weaker UK economy and consumer. There certainly have been
there is little reason to expect them to change their behaviour
some high profile profit warnings amongst these companies, but
because of it. For sure, the consumer environment has weakened
many have actually held up surprisingly well. A lot of the
moderately since the vote, but much of this can be explained by
underperformance can be explained by a valuation de-rating: The
negative real wage growth. The fall in sterling has caused import
median price-to-earnings (p/e) ratio for the consumer cyclicals
prices to rise, resulting in inflation in excess of wage growth. This is
group has fallen from 16x at the beginning of 2016 to 13x today,
certainly a head wind but it may prove a temporary one. Sterling is
although there is a wide range with some high street retail and
well off the lows - $1.35 as I write this - so the outlook for next year
leisure companies languishing well below 10x. Over the same
is much improved on this front. Moreover, employment itself has
period, the p/e ratio for the overall market has actually risen
remained buoyant. Real wages did not grow during 2017 but total
modestly from 15.5x to 16.0x3.
hours worked have continued to show a steady rise, and looking
Allianz UK Opportunities
forward the ongoing rises in the minimum wage should provide the UK will have the opportunity to change the way it trades with
some support to the consumer and the economy. the rest of the world, potentially for the better – although actually
achieving this this is far from guaranteed. I personally voted
UK employment – total weekly hours worked
Remain because I think the supposed benefits from being
outside the EU are unproven, very long term and will involve a lot
of “execution risk”. But I remain open minded as to how this may
play out and I certainly wouldn’t write off the long-term
prospects for the UK economy.
Interpreting sterling moves
Another misunderstood factor at play is the fall in the pound.
Some commentators have interpreted this as a sign of the
weakness of the UK economy, resulting in higher inflation and
potentially forcing the Bank of England to raise interest rates. I see
the fall in the pound as part of the adjustment process - a one off
correction that improves the UK’s terms of trade in response to a
Source: Office for National Statistics, Bloomberg, January 2018
negative external development. In economics jargon, this is
Look at business investment and a similar picture emerges. At the known as “the home market effect”. In a free trade area, in which
time of the Referendum vote, there was no shortage of dire there are products or services that can easily be produced in
warnings from the doom mongers predicting a mass exodus of different countries, the home market effect says that production
business and a collapse in investment spending. The reality is will tend to gravitate towards those areas with geographic
that business life has plodded along in a somewhat subdued economies of scale because this minimises the frictional costs
state – not great but certainly no disaster. Most companies I such as transportation and logistics. Production may still
speak to are nervous about Brexit but they have not radically continue in other areas but there will need to be some offset
altered their investment intentions. Of course this could change such as lower wages in order to compensate for the higher
for the worse depending on what ultimately happens, but for frictional costs.
now at least the situation appears manageable.
Now think about the UK’s financial services sector in the context
UK business investment of the home market effect. Many commentators expect a mass
exodus to Europe in a post Brexit world as the City of London
loses its relevance. More likely in my view is the downward
adjustment in the pound serves to compensate (through lower
costs) for the increased frictional costs of doing business in a City
of London that is outside of the EU. Of course this doesn’t mean
all is well for the financial sector. There will be some jobs that
have to move for regulatory reasons and the pound may yet need
to fall further in the event the exit deal is very bad for the UK. But
ultimately I expect the pound to do most of the heavy lifting here.
It is also worth keeping in mind those parts of the UK economy
that stand to benefit from a weaker pound, such as the poorer
manufacturing areas or the tourist industries. These areas could
Source: Office for National Statistics, Bloomberg, January 2018 see a renaissance in a post Brexit Britain.
The longer term outlook is clearly much harder to call. The EU is a The political reality
large free trade area in which the UK conducts a significant Some have argued that domestic politics – the fear of Jeremy
volume of its trade. The country is also deeply embedded within Corbyn - rather than Brexit explains the low valuation of domestic
intra European supply chains, many of which rely on standardised stocks. But this is not convincing either. First of all it would need
practices, rules and regulations (“non tariff barriers”). Other the Government to fall. The ruling Conservative party is
things being equal, losing access must be an economic negative desperate to keep Labour out and ensure that they can push
because the cost of trading with the EU will go up. But, as is through their version of Brexit. They will do everything they can
usually the case with economics, other things are not always to avoid an election, which paradoxically strengthens the Prime
equal. The EU is itself a protectionist block. The region’s taxpayers Minister’s position even though many in her party would like to
incur significant costs subsidising industries such as agriculture replace her if they could. Secondly, it is true that Labour did
which are not competitive internationally. Leaving the EU means surprisingly well in the 2017 General Election, but this was against
Allianz UK Opportunities
very low expectations. With hindsight the Labour vote benefited because companies have to pay workers more so that they can
from a surge in turnout amongst young voters attracted by the afford their living expenses.
prospect of free university tuition and disaffected Bremainers that
wanted to punish the Tories. These swings may not be sustained. It would obviously be a gross simplification to say that housing is
More importantly, they have little if anything to do with some of the only issue that matters, but I do believe that many of the UK
the supposedly hard left anti-capitalist policies that Labour have economy’s structural problems stem from housing. It is certainly
proposed. Finally, even if Labour were to get elected, it is not clear not a great situation, but equally it is not a disaster, and certainly
to me that this would even be that bad for the economy. I have not bad enough to preclude looking for investment opportunities
read the Labour manifesto and it is a long way from the scare amongst some very cheap domestic stocks. It leads me to focus
stories that I hear people talking about. There is a suggestion of my attention on strong franchises with distinct business models,
raising taxes, but this would fall on the richest 5% of the population companies that have a good chance of doing well even in a weaker
(those earning over £80,000 per year), and the proceeds would be environment. Where might these opportunities lie and how to go
used to fund increased spending and support for poorer sections about sifting the wheat from the chaff?
of society. Not great news if you’re a highly paid banker, but Since they account for nearly 25% of the total, the consumer
possibly not such a bad thing for an economy where inequality has cyclical companies are the obvious place to start when
been rising and consumer spending has been under pressure. formulating a stock picking strategy for the UK domestic group.
Overall the tone of the Manifesto reminds me of the mixed The valuation case is clearly compelling, both in absolute terms
economy models in Europe. This may not be everyone’s cup of tea but particularly relative to market. However there is another factor
but it’s hardly a disaster. holding the consumer cyclical companies back, in addition to
The economic prognosis Brexit related concerns: their business models are under varying
degrees of pressure from the ongoing online channel shift.
Putting Brexit to one side, it is the health of the UK economy itself
where I have the most concerns. This, combined with valuation Specific threats: online disruption?
considerations, was the main reason for the Fund’s very low The problem is most apparent for traditional “bricks and mortar”
weighting to UK domestic stocks in the period prior to the EU retailers. These companies are heavily reliant on in-store sales and
Referendum. Today, with valuations having de-rated so far, the must maintain an expensive store base to support this part of their
question now is whether the UK economy’s predicament is so bad business. Unfortunately their customers are increasingly choosing
as to justify these valuations. to do their shopping online, which means they must invest heavily
in online capabilities. But this is also an expensive business to be
The primary problem facing the UK economy is the high level of
in. A slick website backed up by an efficient logistics and delivery
consumer debt. The housing market is critically important in the
service are necessities just to have a seat at the table.
UK, much more so than in other countries. Hampered by a
sclerotic planning system and numerous vested interest groups, Furthermore, online is usually more competitive due to the price
successive governments have totally failed to deal with the supply transparency it gives to the consumer. Amazon’s entire business
issue causing house prices, particularly in the south east, to keep model is based around providing the lowest prices possible
on rising to ever higher multiples of household income. combined with the best service and the company is happy to run
Government support schemes such as Help to Buy have made it at wafer thin margins to achieve this. Many traditional retailers
easier for people to buy but have done nothing to aid supply and find themselves stuck between “the rock” of stagnant or declining
so arguably have made the underlying situation worse. The result store sales and “the hard place” of brutally competitive online
is highly indebted consumers and a financial system whose competition. For many it is hard to see an obvious solution. Some
primary purpose is to fund and support the housing market. won’t survive whilst others will be weakened, forced to invest
more and operate at lower profitability. Valuation alone will not be
I am not in the camp that sees this all collapsing in on itself,
a defence here. The good news is that the outlook is far from dire
primarily because I don’t see how this can be allowed to happen.
for all domestic consumer facing companies, even amongst the
The country is limit-long the housing market - it is too big to fail.
traditional bricks and mortar retailers. The potential investment
But this fact has other implications. It means that interest rates are
opportunity lies in finding those companies with business models
likely to stay low for a very long time so that the debt can easily be
that are misunderstood, where low valuations imply cyclical and
serviced. I expect this to remain the case in the event inflation
structural problems but where fundamental analysis shows these
were to rise again. The currency may also stay weak as interest
fears to be misplaced. The retail sector itself offers an interesting
rates lag other developed countries. And high housing debt means
case in point.
the outlook for consumer spending is likely to remain subdued
since consumers must keep diverting large chunks of their Identifying vulnerable businesses
disposable income to debt service. Finally persistently high house
prices weigh on corporate competitiveness and productivity To understand how vulnerable a retailer’s business model is, a
sensible place to start is the product itself. Here I think there are
Allianz UK Opportunities
two critical variables to consider: Is it easy to deliver? How unique profitable gross margin sale for store based retailers. But books
or differentiated is it? are easy to deliver and most consumers are very happy to buy
them online. No surprises that this was one of the first products
The economics of delivery matter enormously because this is
that saw its profit pool decimated by Amazon.
one of the main costs for a pure online business model. Note that
it is the total cost of delivery that matters here – i.e. including the There are a number of product categories in the middle ground,
cost of returns and the amount of stock that has to be held to such as apparel and grocery where online delivery works but it’s
service the customer base. Also delivery cost needs to be not that profitable, however the danger is that these categories
expressed in terms of the product’s profitability. A high gross may be moving to the left over time as logistics systems and
margin product lends itself better to a pure online model supply chains improve. That doesn’t mean its curtains for the
because there is a larger in-store profit pool for the online retailer traditional store based retailers, but they will need to make sure
to go after. they keep up with the pure online operators which could prove to
be expensive in terms of capex and margin.
Product differentiation matters because this may indicate how
likely consumers are to become comfortable with a pure online The traditional consumer staples categories are also under threat
sale. Branded products typically fare better, particularly when from online models. These products have high gross margins
consumers like to touch or feel the product. And even if sales do and many are easy to deliver. Historically consumers have been
move online, the brand owner has a better chance of controlling prepared to pay a premium for these trusted differentiated
the distribution and pricing than they would for a homogenous brands (top left quadrant), but there is increasing evidence that
product. Some product sales also involve a degree of assistance this is changing now as consumers are more willing to trust
or support due to the product being unique or customised to online only brands. Amazon for example is already one of the
some extent. Again this is less well suited to pure online models largest retailers of batteries via their own brand.
because the customer will often need to be in a physical space
Products that are most likely to weather digital disruption best
anyway to see the product and discuss the options.
are those that score well on both of these variables (top right
The schematic above combines these two variables together. By quadrant). It is here where consumers will be less likely to opt for
locating where a particular product sits and, importantly, where a pure online sale and, even if they do, fulfilling that sale much
it may be moving to in future, it is possible to gauge how exposed more profitably than a store sale is difficult to achieve with
it is to the threat of online disruption. consistency, making the traditional retailer less vulnerable to a
lower cost online competitor. This thinking partly explains the
The worst place to be is in the bottom left quadrant. This is the
two UK retail companies owned in the fund today.
graveyard of online disruption. Books used to be a relativelyAllianz UK Opportunities
Two undervalued UK stocks: DFS and Howden buy it. It is an infrequent sale that requires a high degree of
assistance and customisation. The gross margins are relatively
DFS Furniture is the UK’s leading retailer of upholstered
attractive compared to many other sectors, but delivery is
furniture. The company has 30% market share which it has built
expensive due to the bulky nature of the product. Much like sofas,
up over many decades of organic and acquisitive growth. Sofas
these attributes are specific to a kitchen and are unlikely to
are bulky, heavy items that are expensive to deliver. Most people
change much in future. Howden’s business model is vertically
like to sit on a sofa before they buy it, which is why companies
integrated. They design and manufacture much of their own
trying to sell sofas usually have some sort of physical presence. It
product and ensure that they always have excellent availability of
is also not really possible to run an in-stock model. Consumers
stock for their customers. That they sell only to the building trade
like to have a lot of choice when buying a sofa, making it
provides the business with a degree of insulation from online
impractical for a sofa retailer to hold everything in stock. Instead
price transparency – a subtle but important point. Trade
the industry operates a made-to-order model which relies on the
customers all receive a confidential discount from Howden and it
retailer having a strong supply chain that can reliably fulfil
is then up to them how to price the kitchen to the end customer,
customer orders. Importantly these attributes are intrinsic to the
who as a result never really knows the actual price that was paid
sofa itself and help to explain why online only models have not
to Howden for their kitchen.
really taken off. It seems unlikely to me that this will change
greatly in the future. For sure, over time customers will do more Much like DFS, the financials show a clear picture of scale leading
and more research online and may become more comfortable to superior economic returns. Howden has consistently delivered
buying online. But this fact alone should not be sufficient to higher organic growth and higher returns on capital that all of its
undermine DFS’s strong market position since any online only peers. Our own regular Grassroots research has shown that this is
competitor would still need to replicate DFS’s supply chain, not coming at the expense of customer service, price or quality.
distribution and advertising reach - the latter alone amounting to Indeed Howden usually scores best in class overall when we
some £80m in spend per year, more than three times the size of speak to trade customers. At the time of writing Howden shares
the next largest competitor. are valued at 13.5x cash adjusted earnings. This is higher than
DFS and most other domestic UK retailers, which reflects the
Looking at DFS’s long-term financials reveals a consistently
more consistent organic growth the company has delivered.
higher level of profitability than smaller peers, suggesting that
However, in my opinion, it is still not especially expensive in
the company is deriving a genuine financial benefit from scale.
absolute terms and particularly compared to the market as a
Most recently the company has been using the current weaker
whole.
trading environment to further strengthen its market position by
mopping up struggling competitors at knock down prices. Looking forward, I am optimistic that both DFS and Howden will
Management aim to run the business at 1.5x net debt / EBITDA, deliver strong returns for the Fund through a combination of
which some analysts have argued is too high for a cyclical retailer. dividends, earnings growth and a re-rating. The latter may require
I have some sympathy with this, however this is not a show some patience as market sentiment could remain depressed as
stopper because the business model itself is resilient. Even during Brexit negotiations drag on and the consumer environment
the global financial crisis, when a number of its competitors went remains subdued. But in the meantime both companies have
bankrupt, DFS produced an EBITDA margin of 8%. In the unlikely been improving their competitive advantages, generating strong
event this happens again, the company would be well within levels of cash flow and paying healthy dividends.
their debt covenants and should have no difficulty at all servicing
their debt. DFS shares have performed poorly over the past two Opportunities in Leisure
years. Like for like sales fell during 2017, impacted by a weaker Another area that greatly intrigues me is leisure and
consumer environment and very unfavourable weather over the entertainment, where share prices have also been hit hard in the
critical bank holiday trading periods. This has caused a substantial period since the EU Referendum result. This is understandable
de-rating of the shares, which now sit on 10x cash backed and consistent with the stock market’s broader worries as to the
earnings. I think this is a very compelling valuation for the market health of the UK economy and consumer. In contrast to the retail
leader in an industry that, whilst mature, is not structurally sector however, the long-term outlook for most of these
challenged and which I believe has the potential to grow over the companies is brighter for two reasons.
long-term at least in line with GDP.
Firstly, online disintermediation is a much less serious risk. Most
Howden Joinery is the UK’s leading designer and retailer of leisure or experience-based activities still happen somewhere
fitted kitchens, with 25% of the overall market and over 50% of the and involve some physical participation or interaction with other
trade market. Kitchens also don’t lend themselves well to online people. Whatever one thinks about the prospects for virtual
only sales. Aside from the very low end, most customers like to reality, it is hard to imagine a world in which consumers no
touch and feel the kitchen they are going to live with before they longer want to consume any traditional leisure andAllianz UK Opportunities
entertainment. Companies that sell these products and services to cost inflation that the company has struggled to absorb. Finally,
should be able to prosper over the long-term provided they as often happens in these situations, structural concerns relating
invest in their assets and make sure ensure they are offering what to pubs as an industry have returned to the fore. The first two
customers actually want. factors are clearly not helpful but I believe they are largely cyclical
in nature and already reflected in the extremely low valuation of
Secondly, there is evidence consumers are increasingly
the shares. It is true that on-trade spending on beer has been
preferring to spend their discretionary incomes on leisure
declining, but this has been the case for over twenty years now.
activities at the expense of physical goods. It is not clear exactly
Well run pubs have offset this trend by convincing consumers to
why this is happening, although in part it probably reflects the
spend more on other drinks and food. I see no reason why pubs
behavioural preferences of Millennials, a group which is growing
cannot continue to do well provided they are offering an
in importance demographically. Whatever the reasons, the
experience that consumers actually want. I am confident, that if
trend, as shown in the chart below is pretty clear.
Greene King management understand they will make the right
Consumer spending growth by category investment decisions across their asset base.
10% The Fund’s investment in Greene King has so far been
8% disappointing with the shares having de-rated further from our
6% initial purchase price. At the time of writing, the free cash flow
4% yield is well north of 10% and the price to book value is 0.75x, on
2% an asset base a large part of which has not been revalued for
0%
many years. This is a huge margin of safety for a largely asset
-2%
backed business and certainly sufficient to compensate for the
-4% Apparel Foodservice
Bars and cafes Restaurants prospect of a short term period of weaker trading.
-6%
Store retailing Department stores
-8%
Ladbrokes-Coral is a betting company I have followed closely
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
for a number of years. The company struggled with their online
Source: Euromonitor, Berenberg, January 2018 offering for a number of years, causing them to lose a lot of
market share to competitors. But the combination of the merger
Whilst valuations here are generally higher than in the domestic
with Coral (which has a superior online platform) and increased
retail sector, in most cases they are still low by historical
investment has now largely rectified this problem. Momentum
standards. There is also wide range of companies in different end
within the business has turned positive, evidenced by a run of
markets, some of which are quite niche with their own internal
earnings upgrades over the past 12 months. I bought shares for
dynamics and long-term drivers. All of this makes for fertile
the Fund in September of 2016 after a very strong meeting with
ground for stock picking and it has been key area of focus for me
management which convinced me that the operating
over past 18 months. The Fund currently has 10% exposure across
momentum within the business would continue. At the time the
four quite different companies, three of which have been added
shares were languishing on a very low valuation due to the
since the EU Referendum vote.
political cloud hanging over the entire sector. The long-running
Four from the fund: regulatory review into fixed odds betting terminals (FOBTs) is
likely to recommend a reduction in the maximum stake to
Greene King is a diversified UK pub company with both a anything from £2 to £40 and where this comes in will have
tenanted and managed portfolio of pubs, the latter including a significant implications for the profitability of the retail shops
number of brands across different price points. This is a capital since FOBTs are a key component of shop profitability. But the
intensive industry because the pubs are mostly owned outright shares were already pricing in the worst case scenario, hence
and when they are managed internally they must be invested in buying in the face of this uncertainty was entirely logical. Since
continually to ensure they are appealing to consumers. Greene then Ladbrokes-Coral has been the subject of a bid approach at a
King has demonstrated a strong long-term track record of capital substantial premium from GVC Holdings, a pure online
allocation stretching back many decades. The combination of competitor that is more geographically diversified. The deal logic
organic and inorganic growth has allowed a steady is consistent with the broader trends within the industry that
compounding of asset value, free cash flows and dividends. point towards increased benefits from scale. The demands of
However since the EU Referendum vote, the shares have found technology, marketing and regulatory compliance are likely to
themselves under a dark storm cloud, hit by a number of grow over time, in my view, and if so, this will favour the larger
negatives. Firstly, sentiment towards the UK consumer has existing incumbents.
deteriorated and this has, to some extent, been reflected in
weaker trading at the company, at least during the second half of Ten Entertainment is the owner and operator of the “Tenpin”
2017. Secondly, the mandated rise in the minimum wage has led brand in the UK ten pin bowling market. The company is the no.2Allianz UK Opportunities
in the market behind Hollywood Bowl. The industry has gone two main reasons for this. Firstly, with the benefit of hindsight, it
through something of a renaissance since the depths of the is clear that the company had been mismanaged for a number of
2008-9 recession when the combination of a consumer years. Previous management was overly focused on opening
downturn and the impact of the smoking ban led to a near death new centres and neglected to invest in their existing estate which
experience for most ten pin bowling operators. Long gone are had become increasingly tired and uncompetitive. Secondly, in
the days of dark and dingy bowling alleys, uncomfortable shoes order to support the growth of the market, the Football
and unwelcoming arcade halls. Tenpin and Hollywood Bowl have Association made funding available for low cost competitors
been moving the offering away from a niche specialism so that it entering the market. This further exacerbated the problem by
appeals more to families and friends as a leisure activity. This has making it even harder for Goals to justify their premium pricing.
meant making the venues more visually attractive, with The good news is that all of this is in the process of being
improved food and beverage offering and a different arcade rectified. The company has a refreshed and high quality Board
offering. It has cost a lot of money to do this, but the results speak that has taken what I feel are the necessary steps, including
for themselves. Both companies have delivered impressive raising a small amount of equity in order to fund an extensive
organic growth, taking significant market share from the tail of reinvestment programme to upgrade all the pitches and
under-invested independent operators. Moreover they are also clubhouses. Much of the capital expenditure has already been
now highly profitable, which makes it seem likely in my view that spent but I believe it will take until 2018 and 2019 until the impact
this process could continue. really becomes clear in terms of improved sales growth, however
early signs are encouraging. In addition, Goals has recently
Unusually, I bought shares in Ten Entertainment at the company’s
announced a 50 / 50 joint venture partnership for its US business
IPO earlier in the year. The price, which came right at the very
with City Football Club, the owner of Manchester City, one of
bottom of the range, was a very attractive one. The free cash flow
largest and well known football brands in the world. This joint
yield was well above 10% and the company had very little debt on
venture arrangement provides the funds to roll out the US
its balance sheet. The shares did very little until the company
business to 6 centres and also the use of all CFG’s branding and
reported half year results in September 2017, which showed
marketing relationships. It was also done at a valuation very
continued organic growth and profits growth. This caused them
substantially in excess of that which the shares trade on. So whilst
to rally nearly 50% into the year end, and I believe the company
this investment has been very frustrating and disappointing for
has the potential to grow further.
the Fund, it is potentially one of the holdings I am most excited
Goals Soccer Centres is the UK’s leading operator of outdoor about.
small sided soccer centres. The company has 46 centres in the The overall strategy
UK and 3 in the US. The end market is small and niche but it is
growing. In the UK, soccer remains a key hobby for many people What does all this mean for the Fund as a whole? The chart below
both recreationally and on a competitive level. The small sided shows how much of the Fund has been invested in UK domestic
format is more practical for most people and as a result has been stocks over the past three years. From a very low base in 2015, the
taking share from 11-a-side, a trend which seems likely to exposure has risen to just shy of 40%, most notably during the
continue. In the US the dynamics are even more attractive latter half of 2016 and 2017 as the Fund has added new positions
because soccer is very popular but the market is underserved, such as those in the consumer sector outlined above (the pink
giving Goals an excellent opportunity to roll out their model. bars), but also a number of other interesting companies in other
Goals has a unique business model in that most of their centres domestic sectors. But it is important to remember that over 60%
are held on long leasehold land that is owned by public bodies. of the Fund is still invested predominantly outside of the UK
Goals provide the facility which is available for use by local economy. This has been an important shift but the Fund is not
schools during the day with the commercial operation running in betting the farm on the UK economy.
the evening and at weekends. It is has taken many years to build
Portfolio exposure to UK domestic stocks
up this position. Public bodies are typically conservative, slow
moving and not keen on letting go of their land unless it is to an 45%
40% UK domestic defensive
established operator. The same is true in the US where Goals had 35% UK domestic cyclical
been operating a test site in Los Angeles for many years and only 30% Domestic consumer cyclical
25%
now is commencing a broader roll out. 20%
15%
10%
Of the four companies that the Fund owns in the leisure and 5%
entertainment space, Goals is the only one that was held before 0%
12/31/2013
12/31/2014
12/31/2015
12/31/2016
29/12/2017
3/31/2014
6/30/2014
9/30/2014
3/31/2015
6/30/2015
9/30/2015
3/31/2016
6/30/2016
9/30/2016
3/31/2017
6/30/2017
9/30/2017
the EU Referendum vote, although most of the current position
has been bought in the past year. It has not been a successful
investment so far. At the time of writing, the shares are valued at
9x p/e and are languishing close to their all-time lows. There are Source: AllianzGI 29 December 2017Allianz UK Opportunities
A natural question to ask is why the Fund hasn’t gone further, capitalise on potential opportunities should this occur. And
given the arguments I’ve put forward in this report. One of the outside of the UK, the Fund is still finding compelling investment
most challenging aspects of fund management is to achieve the opportunities in specific areas such as energy, aerospace and
appropriate balance of aggression and defensiveness for any defence (a subject for a later report). Whilst these have mostly
particular environment. Although I see very compelling value now outperformed the Fund’s UK domestic holdings, they
in UK domestic stocks, there is no escaping the fact that the UK is nevertheless continue to be attractive.
still in a highly uncertain situation. The situation is fluid and liable
to change for better or for worse. Investor sentiment is jittery to
say the least and I would not be surprised to see valuations fall Matthew Tillett
even lower in the short term in the event of political or economic
setbacks. It is important the Fund holds back some firepower to January 2018
To find out more please visit www.allianzgi.co.uk
Allianz Global Investors GmbH, UK Branch, 199 Bishopsgate, London, EC2M 3TY
1 Source: Bloomberg, January 2018.
2 Source: Bloomberg, January 2018.
3 Source: Bloomberg, AllianzGI estimates, January 2018
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