Rathbone Income Fund Update March 2018

At the start of the year, we believed that 2018 would throw up many challenges, and the first quarter has not dispelled this notion. Whether or not we stand at the cusp of a meaningful move in equity markets remains to be seen, but the mood music has certainly taken on a more worrying timbre.

The Rathbone Income Fund outperformed a falling market during the quarter. As detailed in our previous letters, our portfolio construction / allocation has been informed by a hypothesis that the era of low interest rates, high asset prices, and low volatility is going to come to an end. Therefore one might have expected us to outperform a falling market, and so we did, although the effect was certainly dampened by one stock-specific issue, highlighted below. In the same way that our defensive positioning mitigated our participation in the risk-on trade in 2017, so we have seen the reverse impact this year. We have observed a correlation between improved relative performance and a pick-up in volatility. We will expand on this late in this letter.

Performance review

3 months 6 months 1 year 3 years 5 years Rathbone Income Fund -6.09 -5.02 -4.30 12.99 45.54 IA UK Equity Income sector -6.11 -3.25 0.29 14.07 40.95 FTSE All-Share index -6.87 -2.25 1.25 18.63 37.57

Source: Financial Express 31/03/2018

1.00

0.50

0.00

-0.50

-1.00

-1.50

-2.00

SSE

DCC

Senior

Relx PLC Relx

Bunzl Ord Bunzl

Trust

Altria Group Altria

Greene King Greene

BAE Systems BAE

HSBC Holdings HSBC

UDG Healthcare UDG

Headlam Group Headlam

GlaxoSmithKline

Reckitt Benckiser Reckitt

Royal Dutch Shell B Shell Dutch Royal

Daily Mail &General Mail Daily

Lockheed Martin Corp Martin Lockheed

Big Yellow Group REIT Group Yellow Big

Dechra Pharmaceuticals Dechra British American Tobacco American British Micro Focus International Focus Micro

Source: Rathbones. Statpro

Frustratingly, the biggest influence on performance was the holding in Micro Focus International. We refer to our previous investment letter for the detail of what happened, but in brief, the company warned on profits and the shares halved. We remain holders of the stock. Our work on valuation suggests limited downside in the medium term (although our longer-term conviction has diminished), but the shares are likely to be volatile, and there is heightened business risk. We hope for improved newsflow as the year progresses, and will reassess on this basis and subsequent price action. Having trimmed, the current holding is 1% of the portfolio, which we believe is appropriate for the risk we are taking.

The other principal laggards are core FTSE 100 positions in British American Tobacco, Relx, Reckitt Benckiser and Royal Dutch Shell. All four produced, in February, preliminary results that, whilst robust, undoubtedly failed to impress a demanding market. Whilst each of the above has idiosyncratic issues (proposed nicotine legislation in the US; difficult price negotiations with German academics; M&A indigestion / meagre organic growth; and intense focus on cashflow, respectively) share price weakness reflects general disaffection combined with a perceived lack of catalyst.

On the positive tack, Dechra Pharmaceuticals has continued to steam ahead, following a well- received fund raising and accompanying acquisition in January. This has been a terrific story for us over the years, but with the shares now pricing in perfection, we have been mindful to harvest profits on a regular basis. Our faith in GlaxoSmithkline has been repaid by their disciplined decision to step away from bidding for Pfizer’s consumer health business. The positive market reaction to this news, and the subsequent announcement that they are buying the piece of the Novartis joint venture that they do not already own, pleased investors, and the shares reacted accordingly.

How are we seeing the world?

To recap, our narrative for 2018 has focussed on three elements: globally, interests rates are low, asset prices are high, and volatility is low. On rates, it is evident that Central Bank policy in the US, UK, and Europe is reverting to more ‘normal’ behaviour. What is harder to predict is the overall quantum and timing of any moves, and importantly the market reaction. The chance of a policy error, especially in the UK, is high. On asset prices, there are arguments to support both the bulls and the bears. Although we cite, amongst other measures, the high level of the Cyclically Adjusted Price Earnings (CAPE) ratio as evidence of extended pricing, we accept that this analysis is notoriously poor at timing market reversals. However, it is volatility to which we turn our attention.

10 year VIX. Source: Rathbones; Factset.

The VIX Index is a measure of expected future volatility, calculated using S&P 500 Index options, of equity returns, with volatility being the statistical measure of dispersion for the given security or index. Apologies for the course in statistics 1.01, but we wish to be clear in this definition of risk, versus our interpretation, which is the threat of a permanent loss of capital. However, for the purpose of this discussion, we will equate low volatility as evidencing complacency, and higher volatility as a harbinger of greater risk aversion.

If investors were complacent at the start of the year, they may be less so 13 weeks in. Whether it is the data scandal enveloping Facebook, and by extension other harvesters of customer data over the web, or President Trump lambasting Amazon over the Tweetosphere, the shares of the technology giants latterly have come under downward pressure. At this juncture we should not overstate the situation; however, technology giants now represent seven of the world’s ten largest companies by market capitalisation. What happens if investors no longer believe the narrative around paying any price for monopolistic category-killers, with no reference at all towards any regulatory, political or public response? If they de-rate, so will global equity markets.

Secondly, whether Trump has finally rung the starting bell for a potential global trade war remains to be seen. It is unsurprising that the economic nationalism that tariffs represent is erupting to the surface. Evidence of the demise of globalisation is manifest clearly in Trump’s zero-sum bilateral view of trade negotiations; and the domestic success of his argument is itself a symptom of the disenfranchisement that has grown in the ten years since the Global Financial Crisis. Whilst we contend that negotiations will ultimately stave off an all-out trade war, and that wiser heads will prevail, these risks are yet to be reflected fully in investors’ attitudes.

Source: Rathbones; Factset

Back to volatility then. The first spike, at the beginning of February, in the VIX was instigated by fears that the US Federal Reserve has been too slow in anticipating inflationary pressure, and that rates in the US might move ahead more rapidly than foreseen, and on the 8th, a hawkish Bank of England statement predicted earlier and faster rate rises here in the UK. The start of March saw the opening salvos from Trump, as he suggested that the US would begin to impose tariffs on imports of steel and aluminium, and two weeks later, Facebook began to feel the heat, following claims that data firm Cambridge Analytica used leaked information to influence the Presidential elections.

When volatility picks up, we do gain solace from our positioning in the more defensive, value- oriented, cash generating, and dividend paying names in our universe. It is comforting to observe the recovery in names like GlaxoSmithkline, where the combination of depressed investor sentiment, positive news flow, and lowly valuation supports the share price just as risk-aversion is increasing. We inevitably discuss sell discipline when things go wrong, but what about when things go right. We sold Imperial Brands close to the peak last year, disbelieving the valuation and rumours of a bid; now the shares are cheap, and unloved, and fortune favoured us as we re- introduced the name just as the tariff tantrum was evolving towards the end of the quarter. Our UK domestic names are cheap, facing as they do the challenges of Brexit, inflation and a poor economy. Yet this is old news, priced in to the shares, and when new global shocks impact the system, investor attitudes to the UK begin to change.

We are not crowing about a few successes at the end of a difficult period. However, we are comfortable with the positioning outlined in previous letters, focusing as we are on quality, value, late-cycle industries, defensive and cheap good UK domestic names.

Volatile markets are scary, but they also proffer opportunity. The experience of the last few weeks has not changed our view.

Recent Trading: There is little to report on the trading front, other than the odd trimming of the sails. The most outstanding deals to report are a reduction in our holding in Rio Tinto, and some slow but steady buying of Restaurant Group.

Companies met during the month: Bunzl, Legal & General, Restaurant Group, Headlam, Tarsus, Hansteen, Close Bros., WEC Energy, and a conference call with Micro Focus.

Carl Stick Fund Manager

Carl Stick is manager of the Rathbone Income Fund. This is a financial promotion relating to the Rathbone Income Fund. Any views and opinions are those of the investment manager, and coverage of any assets held must be taken in the context of the constitution of the fund and in no way reflects an investment recommendation. The information contained in this note is for use by investment advisers and journalists and must not be circulated to private clients or to the general public. Source performance data, Financial Express, bid to bid, net income re-invested.