Three cheap shares I’ve bought for City of London Investment Trust

Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to the latest in our Insider Interview video series. Today, I'm joined by Job Curtis, fund manager of the City of London (LSE:CTY) Investment Trust. Job, thanks for coming in today.

Job Curtis, fund manager of the City of London Investment Trust:It's a pleasure.

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Kyle Caldwell:So, Job, could you start off by summarising how the trust invests in order to provide growth in both the capital and the income?

Job Curtis:Well, City of London has at its core portfolio-consistent companies. But how I invest is I'm trying to select companies that can grow their profits and dividends over the long term, but also by not overpaying for them. Valuation plays a part of an important role in my stock selection. Because even if you're investing in a good company, in my opinion, if you overpay and pay too high a price, then you can lose money share price-wise. Similarly, shares might appear very cheap, but they could be cheap for good reason. So I'm trying to avoid those so-called value traps, which have struggled to grow at all and end up cutting the dividend. So I need to be in companies with good cash flow, which are able to invest enough for the long term to grow the profits and dividends over the long term.

The other facet of the investing is that I'm quite a conservative personality, so I think with any fund manager that the portfolio will reflect the person as the fund managers agree. And so City has a conservative portfolio. I like companies with good cash generation and particularly in cyclical sectors. I like strong balance sheets. I don't like a combination of a company with high gearing or leverage or debts in a cyclical sector that can be very dangerous in an economic downturn. Overall, City's portfolio is quite conservative. I mean, if it's a race between a tortoise and the hare, we are kind of more of a tortoise than a hare.

Kyle Caldwell:And what's the split in terms of a company size? Is the majority of the trust invested in larger companies that are in the FTSE 100?

Job Curtis: Yes, City is predominately in large companies. We state that we are going to be predominantly in large capitalisation equities. We have a heavy bias towards FTSE 100 stocks and indeed we also have some 15% of portfolio in some large overseas listed companies, which are all large companies. So we do have some medium-sized and a few smaller companies, but we're predominantly in the large-cap end of the market.

Kyle Caldwell:Being in that part of the market has particularly paid off year to date in 2022. Could you explain why, and could you name a couple of stocks that have performed well this year?

Job Curtis: Yes, I think the large companies have performed much better this year than medium and small companies. I mean, it's partly because if you look in the large part of the market, I mean, one sector that's big in the FTSE 100, in large companies is the oil sector. Of course, the oil price has gone up a lot and that's benefited BP (LSE:BP.) and Shell (LSE:SHEL) for sure.

Also, certain defensive sectors such as pharmaceuticals are mainly found in the large companies, GSK (LSE:GSK) and AstraZeneca (LSE:AZN). I mean, within City of London's portfolio, we hold BP, Shell, Glaxo and AstraZeneca, but particularly important for City of London has been BAE Systems (LSE:BA.), which is a leading defence contractor, where the shares have been very undervalued in my opinion. Because of the Ukraine war, they've had something of a re-rating this year.

And in addition, one area that's been very unpopular for understandable reasons has been tobacco shares and they've actually also had a very good year, given the consistency of their profits and cash generation and British American Tobacco (LSE:BATS) is a big holding for City, which has done well this year.

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Kyle Caldwell:And given that there's been a lot of volatility for the UK market in general this year, have you been looking to take advantage of any opportunities of sectors or shares that potentially now look mispriced? I was also wondering whether any of the mid- and small-cap names have caught your eye as well?

Job Curtis:Yes, I am trawling around in that sort of mid- and small-cap area because obviously valuations come back a lot and it's more interesting. I mean, I'm still quite wary of what you might call consumer discretionary stocks, you know, areas such as travel, leisure and retail. I think the consumer, is under a lot of pressure. I mean, the cost-of-living crisis. So I'm sort of still kind of fairly underweight in that part of the market. But I have spotted some opportunities, you know. Within the mid-cap area, we've bought Hays (LSE:HAS), which is a recruitment consultancy business, is split a third UK, a third Germany and a third Australia-New Zealand and it's doing very well with fairly full employment and wage growth it's benefiting from.

I've bought Wincanton (LSE:WIN), which is a logistics company, which is very cheap and doing well benefiting growth in the fulfilment. And I've also bought Rathbones (LSE:RAT), the wealth manager, which is in a kind of secular growth sector in my opinion, and is one of the leaders in that sector. I am seeing opportunities, but I'm not lowering my criteria at all for investing in mid and small-cap.

Kyle Caldwell:And in order to fund those purchases, have you been selling any of your existing holdings or has gearing increased?

Job Curtis: Well, in the wealth management sector, we had a holding in Brewin Dolphin (LSE:BRW), which has been taken over by Royal Bank of Canada at a very high price as to where it was previously trading. And so really, I've reduced that in order to fund Rathbones purchase keeping money in that sector. And I think that's one of the attractions of that wealth management sector, as you know, is some of the consolidation. I mean, also in terms of other sales, we do make reductions and take profits, in situations, you know, across the portfolio.

In the housebuilding sector, we've had a successful holding in Berkeley Group (LSE:BKG) and I did sell out of that in June. But we still retain holdings in Persimmon (LSE:PSN) and Taylor Wimpey (LSE:TW.). I just felt that against a rising interest rate environment, it was best to reduce some exposure to housebuilders. In terms of the gearing of the trust, no, we've kept the gearing quite low level. It's around 7% at the end of June, which is on the lower end. We have got some very cheap debt, which we've taken out in recent years, so we're borrowing out to 2046 at 2.67%, up to 2049 at 2.94%. These are fixed-rate borrowings and they were struck over the last two or three years when interest rates were extremely low. And they now look, you know, really quite well judged. And I think they're going to benefit City's shareholders for many years to come.

Kyle Caldwell: You've mentioned interest rates being on the rise. Have you been increasing exposure to banks? I can see in the top 10 there's HSBC (LSE:HSBA). Do you own any of the four major players? And I was wondering, why is HSBC in the top 10 and not any of the others?

Job Curtis: We also own Barclays (LSE:BARC) and Lloyds Banking Group (LSE:LLOY), so we've got three banks. HSBC is our biggest holding, it is also the biggest bank by market capitalisation. We're actually underweight relative to the index, but it is a big position. I mean, most of the profits they made out in Asia-Pacific and their great strength is this huge deposit base they've got and they will be a big beneficiary of rising US interest rates because the Hong Kong dollar is linked to the US dollar. So, the banks in general do benefit from rising interest rates up to a point.

Of course, if it tips the economy into recession, then it's not good news for the banks. They start, you know, getting losses from their loans. You have to be a bit careful, but I think the sector is reasonably good value. It's just been a very difficult sector over the years. I think it's been a big political football ever since the financial crisis, you know when the taxpayer had to bail out the banks. I mean people in Whitehall and Westminster have kind of looked very and equivalent centres overseas have been quite careful with the banks. And there are a lot of rules and regulations, when the pandemic hit, the banks were ordered to stop paying dividends immediately. So I think it's a tricky sector in terms of both the kind of political and regulatory interference and also the fact that it will suffer if the economy goes into recession. We do have some exposure to banks, but we're not overweight.

I mean, the sector, which also will benefit to a degree from rising interest rates is insurance. And we have got quite big positions in both life insurance and non-life insurance, and that's an area where we're overweight. And so we kind of prefer to play that area of the market on the rising interest rate theme rather than the banks. So, in life insurance we've got big holdings. Our biggest two holdings are Phoenix Group (LSE:PHNX) and Legal & General (LSE:LGEN), which are very attractive yields and have got slightly different business models. Phoenix has been a consolidator, but it's now growing its business and Legal & General it's got a very strong position in annuities, and then I've also got a big holding in M&G (LSE:MNG), which is a mixture of fund manager and life assurer.

In non-life insurance, we've got a mix. We've got Direct Line (LSE:DLG) in motor and property and casualty that they're suffering a bit from inflation actually of the claims, the cost of making repairs and second-hand cars, that type of thing. But I've got some interesting smaller vehicles such as Beazley (LSE:BEZ), which is a kind of Lloyds-based speciality insurer, which is doing very well out of cyber insurance at the moment. I've also got a big holding in Munich Re, the big global reinsurer based in Germany. So we've got a combination of some very interesting stocks and those offering decent yields and I think prospects for capital appreciation.

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Kyle Caldwell:And as you mentioned earlier, you have some exposure to non-UK stocks. Could you explain why and could you give a couple of other examples?

Job Curtis:Yes, it's partly to provide some diversification in some sectors. For example, in pharmaceuticals, you've just got Glaxo and AstraZeneca, UK listed, in fact Astra has done very well. In City of London, we hold Merck (NYSE:MRK) of the US, which has also done well over the years. We have Johnson & Johnson (NYSE:JNJ), an American company, Novartis (SIX:NOVN) and also Sanofi (EURONEXT:SAN), the French-based international pharmaceutical company, which is a kind of more recent purchase.

Similarly in oils, rather than just having BP and Shell, we have some Woodside Energy Group (ASX:WDS), which is an Australian-listed oil company and we also have TotalEnergies (EURONEXT:TTE), which is French-listed. So, I think gives a bit of extra diversification rather than just having everything riding on kind of a couple of UK-listed stocks.

The other thing is that there's some stocks that you just can't find [an] equivalent [for] in the UK. Just under 10 years ago, City of London invested in Microsoft (NASDAQ:MSFT), which has been a highly successful investment [over] time, it was on a 3% dividend yield and very out of favour and it's really gone up many times since and I've taken some profits, but obviously there's no equivalent to Microsoft in the UK market. I think that's another example of where one can benefit from the overseas.

The other side is that recently some companies have delisted from the UK to overseas markets. This year BHP (ASX:BHP), the miner, basically made its complete listing in Australia rather it was 50/50 Australia/UK before. And just because it does, that doesn't mean, say, you have to sell if it's a good company. It's been a great dividend payer in recent years. So, we've hung on to our BHP. And as another example, Ferguson (LSE:FERG) this year, which was UK-listed is moving its listing to America where its whole business is.

Kyle Caldwell:Job, thank you for joining us today.

Job Curtis: It's a pleasure.

Kyle Caldwell: That's all we have time for, for today. You can check out the rest of our Insider Interview video series on our YouTube channel where you can like and subscribe. Hopefully see you next time.