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My father is a good gardener and shrewd investor. In the aftermath of Covid I was outside, quietly deadheading roses, when he roared up to me and growled: “I’m selling your fund. Everything’s doing too well.” It was a strange complaint, but the disappointing performance that followed that strong year shows he had a point, unfortunately.
It is something I think about every year as the Chelsea Flower Show gets under way. In my father’s view a portfolio should be like a garden — a real garden, not a show garden. If everything blooms at the same time, the chances are that your flower beds will look pretty drab for the rest of the year.
Similarly, if all your stocks are firing simultaneously, you know your portfolio risks soon becoming a collection of yesterday’s stories. You need some of tomorrow’s winners in there — the equivalent of the plants lying dormant, ready to burst into bloom when other flowers fade.
There are good reasons for this. For fund managers, long periods of underperformance are very difficult to endure. Advisers and clients think you have lost the plot and contemplate moving money elsewhere — probably just at the wrong time. We have all done that and looked on in despair as the fund we have abandoned suddenly tops the performance tables.
From an investor’s perspective, you never know when you might suddenly need to draw on your investments. So, while a portfolio without volatility is probably a portfolio without risk and going nowhere, for many of us too much volatility can be damaging.
Those with portfolios heavily weighted towards the handful of US giants that have driven the global index up in the past 18 months may want to remember this. I think that in time breadth and diversity will matter again. Is it time to bank some of your gains and make room in your portfolio for something for next season — in the same way as you might hard prune some of your shrubs to plant something new?
What might you plant for tomorrow? My specialism is UK equities, so in one sense I am talking my own book, but I am not the only one to see real potential building in the UK’s beaten-up smaller companies sector. The big question is when will things turn.
In one important sense a gardener has an advantage over the portfolio manager. Spring follows winter. Bull markets follow bear markets, but the timing of their arrival is less predictable. The average length of a bear market is thought to be nine months. However, the UK market has been in a relatively weak market in a global context since the global financial crisis of 2007, with the weakness being aggravated by Brexit.
People often ask me what the catalyst for recovery might be. Catalysts are easy to identify after the event but often hard to recognise at the time. However, there do seem to me to be some strong signals coming through that things are changing.
Britain is out of recession and the FTSE has broken its record high recently. But it still looks relatively cheap. Company managers are demonstrating their unrest at low valuations and buying their own shares at levels I cannot recall in my working life — last year they spent over £50bn on buybacks.
UK shares are expected to yield 4 per cent in the coming year (mid-caps nearer 3.4 per cent). On average I expect them to return around half that again to shareholders through buybacks.
This reduces the share count, meaning a bigger slice of the profits for remaining investors. At some point that becomes obvious, and the share price corrects. We have seen it recently with banks such as Barclays and NatWest — both big buyers of their own stock — up nearly 50 per cent in just three months.
Meanwhile, I have never known so many of the stocks I hold become takeover targets and often at significant premiums to the pre-offer share price.
This has certainly helped that underperforming trust I alluded to at the start — the Henderson Opportunities Trust. After a painful period when its exposure to promising smaller companies has been out of sync with market tastes, it has risen by more than 25 per cent in six months (almost twice the performance of the FTSE All-Share).
Green shoots? Perhaps. I hope so! You might say it is still too early to pile in to the kind of stocks it holds. But, as any gardener knows, it is a lot cheaper to buy plants young before they mature and bloom.
One thing that could help spur a share price correction for UK smaller companies is a fall in interest rates. It could encourage profitable businesses to press ahead with capital spending on projects that have been on hold and cash investors who have preferred interest payments to equities, to switch, creating a virtuous circle.
Industrials could benefit especially from falling rates. For all the talk of Britain’s dying manufacturing sector, we do have some remarkably good industrial businesses.
Surface Transforms has potential. It has just raised an extra £6mn to build a new facility to increase production of ceramic brake discs, which are much more effective than traditional brakes in slowing luxury electric vehicles with their heavy batteries. The company has suffered a string of mishaps and seen its share price annihilated in the past year. The hope is that it has turned a corner. It has a great product if it can manage its scale up. At just over 1p, its shares have the potential to accelerate rapidly from here.
Renold has also had its issues but appears to have costs under control now. The company, which manufactures precision chains used everywhere from power stations to chocolate manufacturing, has just won a £10.6mn order from the Canadian Royal Navy. Its shares are up 83 per cent over the past year, but in my view the valuation still does not reflect where the company is and its strong order book.
Finally, Invinity — a battery developer — looks interesting. As we move electricity generation to renewables we will need more battery storage to power the grid when the wind is not blowing and the sun has disappeared behind clouds. One big problem with most batteries is the dramatic drop-off in efficiency, as you will know if you have an old smartphone. Invinity’s technology — an alternative to lithium — seems to have overcome this issue. Unlike many younger rivals, Invinity has built and delivered more than 1,200 of its large-scale batteries around the world.
We own all three of these companies within diverse portfolios — or a “mixed border” if you like. It means if they disappoint, hopefully other holdings will flourish and compensate.
Industrial cyclical companies often have relatively fixed costs, which many have managed to cut recently in efficiency drives. An upturn in orders need not require a matching rise in costs, so the proceeds go straight to the bottom line, giving profits a real kick. Analysts too anchored in recent difficulties are not factoring in this potential, so valuations are low. Markets like positive surprises. It might not take much for these kinds of shares to take off.
Remember all this if you are elbowing your way through the crowds to get a glimpse of the show gardens at this year’s Chelsea Flower Show. Imagine those gardens were still there in six months. What would they look like then? Plant and invest for the future as well as today.
James Henderson is co-manager of the Henderson Opportunities Trust, Lowland Investment Company and Law Debenture
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