The Long and
the Short of It

Presenting Threadneedle
UK Extended Alpha Fund

Sponsored by

DECEMBER 2019

INTRODUCTION

Welcome to another edition of SOURCE, a publication that shines the spotlight on selected funds and their managers. This time, Columbia Threadneedle Investments present the Threadneedle UK Extended Alpha Fund, with a profile and Q&A with portfolio manager Chris Kinder, plus supporting analysis from Citywire.

INTRODUCTION

Welcome to another edition of SOURCE, a publication that shines the spotlight on selected funds and their managers. This time, Columbia Threadneedle Investments present the Threadneedle UK Extended Alpha Fund, with a profile and Q&A with portfolio manager Chris Kinder, plus supporting analysis from Citywire.

MORE SKILLS, BROADER OPPORTUNITY SET:
THREADNEEDLE GLOBAL
FOCUS FUND

MORE SKILLS,
BROADER
OPPORTUNITY SET: THREADNEEDLE GLOBAL FOCUS FUND

hile many will acknowledge the valuation opportunities in the UK equity market following the EU referendum, the Threadneedle UK Extended Alpha Fund can exploit them better than most.

Chris Kinder, who has just entered his tenth year of running the fund, has more levers at his disposal than many UK equity fund managers, because he is able to take both long and short positions.

While many will acknowledge the valuation opportunities in the UK equity market following the EU referendum, the Threadneedle UK Extended Alpha Fund can exploit them better than most.

Chris Kinder, who has just entered his tenth year of running the fund, has more levers at his disposal than many UK equity fund managers, because he is able to take both long and short positions.

With a process and philosophy focused on bottom-up stock picking, Kinder works within a very experienced UK Equity team responsible for running over £21 billion AUM* in UK listed companies. ‘We do a lot of work on companies across the FTSE All-Share yet only choose to own a smaller number of conviction stocks. This leaves a large number of companies that we choose not to own and this product enables me to add alpha by identifying those that are mispriced.’

‘We have exposures on the long side that are UK domestic – there are certain incredibly healthy franchises that are able to grow,’ he says.

‘There are businesses that are taking market share and businesses that are losing market share, but because they’re all tarred with a Brexit brush, they’re all undervalued.

‘You can have a better-quality asset at the same price as a really low-quality asset. That’s a source of alpha. It all comes down to bottom-up analysis and stock picking.’

One-quarter of Kinder’s long book is in consumer services stocks and a similar weight is in consumer goods companies. When picking domestic-facing stocks Kinder likes those that do well in a challenging economy, discount retailers being one example.

‘We are seeing people in the UK moving to discounting,’ he says. ‘In a tough economy, you want to shop with the lowest cost provider. So, there are always opportunities. Even in a weak economy there are going to be strong companies.’

A big component of his stock-picking process addresses the issue of whether a share is undervalued or not; a lost art of sorts lately. In particular, he looks to buy companies that are of better-than-average quality but are trading at lower-than-average valuations.

Kinder can make relative value plays among stocks of similar quality – buying shares in an undervalued company and short selling those in a comparatively overvalued one, although he points out that not all his short positions are relative value.

‘If you have two assets of similar quality, with one being cheaply valued and one being expensively valued, that looks like an arbitrage opportunity and is a source of alpha that is available to this fund,’ he says.

That’s just one way of realising excess performance, however. Merger and acquisition (M&A) activity is yet another way in which Kinder has been delivering returns to investors.

‘Another way in which value can be realised is when a third party comes and buys a share off you at a higher price than it was trading at in the stock market,’ he says. ‘That’s a real theme, because we’re seeing massive amounts of M&A.’

Three of his long positions, which typically number around 50, have been taken over during 2019, hot on the heels of two the previous year. And Kinder has a keen eye trained on other likely takeover targets.

‘It’s something that we’ve got a good track record of doing [finding them]’, he says. ‘If I’m getting three takeouts every year, that’s really helpful – when they get taken out, they go at 30% to 40% premium.

*SOURCE: Columbia Threadneedle Investments as at 31 October.

‘If you have two assets of similar quality, with one being cheaply valued and one being expensively valued, that looks like an arbitrage opportunity and is a source of alpha that is available to this fund’

CHRIS KINDER

‘We would never invest in a company solely on the prospect of being taken out, but intellectually, if you think it’s a theme and you think there’s a lot of money in the theme, you’re going to look a little bit harder than you might have done historically.’

Meanwhile, company bosses’ caution on capital expenditure amid a subdued global economy and political uncertainty frees up cash to be spent on acquisitions and share buybacks. While these represent an important source of support for share prices on one hand, they also serve to shrink equity markets on the other.

‘It’s good in that we have an opportunity set to make money,’ says Kinder. ‘The negative side of it, of course, in the medium term is that if it continues, we’re going to be hollowing out our market.’

The fund is firmly in the first quartile of the IA UK All Companies Sector in the past year, returning 10.7% net of fees, compared to the FTSE All-Share Index, which has returned 6.8% (at October 2019).*

The fourth quarter of 2018 aside, it has done relatively well in drawdown periods, too, when the types of stocks it tends to short – more expensive and lower quality – typically lead the market lower, netting Kinder a handsome profit.

A case in point is 2011 when the US suffered its first-ever credit rating downgrade and fears of contagion of the European sovereign debt crisis sent markets plummeting. Threadneedle UK Extended Alpha lost just 2% during that year, against a UK market decline
of 3.5%.*

Moreover, Kinder points to the low level of volatility with which the fund has achieved its returns. ‘One of the best features of it, to use some technical jargon, is the information ratio since I took over. Over this period it has provided disproportionate amounts of return for the risk it takes.’

Despite its strong short-term performance in falling markets, it remains a relatively small fund at less than £160 million – much to Kinder’s frustration.

‘It’s got to be the complexity – I think people struggle with what bucket to put it in and people struggle with the concept of shorting. People might say that it’s neither fish nor fowl. In our view it’s designed to sit within a UK allocation rather than an absolute return bucket.’

The central premise of the fund, however, is that it enables investors to stay invested throughout the cycle. And as we enter a year of heightened uncertainty – for politics, the economy and risk assets like equities – that might prove to be its biggest selling point.

*SOURCE: Morningstar as at 31 October, fund performance net of fees. Past performance is not a guide to future performance.

Performance
Review:

frank talbot
HEAD OF INVESTMENT RESEARCH, CITYWIRE

Performance
Review:

frank talbot
HEAD OF INVESTMENT RESEARCH, CITYWIRE

Threadneedle UK extended alpha: Performance REview

The Threadneedle UK Extended Alpha Fund sits in the top quartile of the IA UK All Companies peer group over both one and seven years on a total return basis.

SOURCE: Lipper, as at 31.10.2019. Risk-adjusted percentiles are calculated in GBP gross of tax, bid to bid, net of ongoing charges and gross of initial charges and with income reinvested at the ex-dividend date. Peer group rankings are based on funds in the IA UK All Companies sector. Market share data based on total assets under management in the IA UK All Companies sector.

Over Chris Kinder’s nine-year tenure the Threadneedle UK Extended Alpha portfolio has handsomely outperformed both the bechmark and the average fund. Generating returns of 130%, compared with 89% for the FTSE All-Share and 103% for the average fund in the category. In addition the portfolio is ahead of the benchmark and the average fund over seven- five- three- and one-year time frames.

Performance review of chris kinder in Alternative UCITS – Long/Short Equity

Chris Kinder looks good on a risk-adjusted basis over both seven and one year time periods in the peer group. This includes both the Threadneedle UK Absolute Alpha and Threadneedle UK Extended Alpha Funds he currently runs, and can be seen by his position in the upper right hand quandrant of the bubble chart. Over the past seven years he has generated second decile risk-adjusted returns, while over the past year he is top quartile. Kinder is ahead of market share leaders from Janus Henderson and Jupiter over both time frames. He has also achieved this while exposing investors to less risk than the peer group average, with his maximum drawdown over the seven years standing at just 9.2%, which places him the second quartile over the period.

SOURCE: Citywire Discovery, as at 31.10.2019. Risk-adjusted percentiles are calculated in GBP gross of tax, bid to bid, net of ongoing charges and gross of initial charges and with income reinvested at the ex-dividend date. Peer group rankings are based on managers tracked by Citywire in the UK. Market share data based on total assets under management by managers tracked by Citywire in the UK.

FUND MANAGER HOT-SEAT:
CHRIS KINDER

FUND MANAGER HOT-SEAT:

CHRIS KINDER

TALK ME THROUGH YOUR STOCK SELECTION – IS IT BOTTOM UP?

Absolutely. Everything on the long side is there because we like it. The way I appraise equities is a function of the quality of the company and the valuation of the company. What I do is buy better-than-average quality at lower-than-average valuation, and on the short side we are essentially looking at over-loved, over-priced and generally lower quality than perceived and deteriorating. The devil is in the business; it’s in the detail. The strength and scale of our team is a big help, of course. We are a relatively large UK team with a lot of experience in this market through market cycles. Our proximity to companies and the fact that we do really robust fundamental work is why the fund is performing well, not because I like Brexit or I don’t like Brexit, or I don’t like Donald Trump or I don’t like China. The portfolio isn’t set up on the basis of UK bad, US good, China bad, Japan good – it’s [all about] the stocks.

 

BASED ON YOUR STOCK-PICKING, WHERE ARE YOU FINDING THE BEST INVESTMENT IDEAS JUST NOW?

Many of the long holdings have been in the portfolio for years. So, it’s not a case of what’s my best idea today. I don’t ever want to make the portfolio dependent on one thing. The biases in the portfolio currently are underweight on large cap, capital intensive, slow growth, mature companies. That would be a feature. We don’t really own big oil, big mining, big banks. We have quite a lot of well-diversified exposure to global travel and leisure stocks and corporate services on the long side. We’ve got a couple of housebuilders. It’s all done on a stock-by-stock basis. We own staple assets and there’s quite a big exposure to the consumer. From the top-down, if you looked at the portfolio, you’d think it was underweight resources, generally neutral on financials with a preference for insurance over banks and overweight consumer spending and corporate spending.

 

WHAT BEARING HAS POLITICAL UNCERTAINTY HAD ON YOUR POSITIONING?

Probably a quarter of the portfolio is exposed to UK domestics. We’re not in the camp at all that Brexit or the election has made UK domestic assets uninvestable. What we want is the highest quality cohort of UK assets that will thrive in whatever economic environment comes to us. We don’t own them because we think the UK’s going to get better and [prime minister] Boris [Johnson] is going to win and it’s all going to be great. That’s not the base case; it’s more that the assets that we own can take market share – they’ve got strong balance sheets, they’re good businesses.

 

SO STRONG BALANCE SHEETS – WHAT ELSE DO YOU LOOK FOR IN A QUALITY COMPANY

There’s a focus on return on capital. There’s a focus on business positioning. It’s about quality, not growth. A very high top-line growth rate is not particularly interesting to me, because it often can’t last. It’s about returns, compounding growth rates, asset quality and market position. We use Porter’s Five Forces analysis, then overlay a view on the balance sheet. Is the business well-funded? Does the business generate cash? If it generates cash, does it deploy it effectively? We are cautious on M&A-led strategies. We prefer organic growth to inorganic. Another feature of quality would be the management and if it’s a team we know well. Are they consistent in their strategy and execution? What is their track record? Do we have a good level of engagement with them? Are they remunerated appropriately? Do they behave with integrity when we see them? We look for quality on a financial metric and on a governance metric as well.

 

IS IT FAIR TO SAY THE PORTFOLIO IS QUITE DEFENSIVE?

It’s balanced. It’s skewed up the market cap scale in that the big capital allocation is probably between £1 billion and £40 billion. We’re certainly light on the mega caps. We don’t do small cap at all. So, we’re in the small large cap, big mid cap space. It’s diversified. It has a quality bias, if that’s what you’re referring to as defensiveness. That is deliberate. Our primary role is to identify good companies that can grow over time, then to make sure we don’t overpay for them. There’s a value filter to it as well. Relative to other competing funds and the market, it’s got a really powerful value tilt. The longs are cheapish, but the shorts are very expensive. One of the real features over the past nine months or so is how overvalued certain cohorts of assets have become. It is incumbent upon us to look into those areas for short ideas.

 

HOW CHEAP IS THE UK? A LOT HAS BEEN MADE OF ITS CHEAPNESS, BUT DO YOU BUY INTO THAT?

There are reasons that the UK market in aggregate terms should be cheaper than other markets. Firstly, it’s got a lower natural growth rate because so much of the UK market is tied up in heavily capital-intensive industries. Think BP and Shell. Think banking, which is naturally low growth, naturally low return, naturally higher yielding. The UK market’s always going to have a higher dividend yield and we’re going to have a lower growth rate – there should be some discount for that. Having said that, there is underlying cheapness across the board. There are perfectly good companies in the UK that are trading much cheaper than international competitors. Then you’ve got this quarter of the market that’s UK domestic that is trading more cheaply because of Brexit. I would say it is cheap, but it’s subtly cheap. There’s definitely a cohort of the market that isn’t cheap. One area is the defensives. That’s where we want to be careful – we don’t own too much and is there an opportunity for shorting? If Brexit is better than people think and the world economy is better than people think, maybe people have overpaid for their bond proxies.

 

STOCK MARKETS HAVE HAD A PRETTY EASY RIDE SINCE YOU STARTED RUNNING THE FUND IN 2010. IS THE BEST YET TO COME FOR A LONG/SHORT STRATEGY LIKE YOURS?

It is a directional fund. Given that it’s a fund that has the ability to go up to 150% long and 50% short, I knew it would be difficult in the first few years because the concept was very hot in the run-up to the global financial crisis. A lot of people believed in these types of strategy because they are intellectually sound, but then they were executed really poorly by the cohorts of people who had gathered assets in the run-up to the crisis. Therefore, there was a lot of cynicism about them. The risk of course, when you’re shorting and writing open-ended liabilities, is that you can lose more than all your money, which is quite a scary concept. I know that because I’ve been doing it for nine years and I did seven years of hedge funds before that. There’s a skillset to managing short positions that is not necessarily well observed in many of the more traditional fund management houses. I’ve always felt that time is my friend with this product. Nearly 10 years in and we’re pleased to see our approach is standing the test of time for our clients.’

To find out more contact your local Columbia Threadneedle Investments representative at columbiathreadneedle.co.uk/contactus

 

CITYWIRE RISIKOBETRACHTUNG

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