Ben Needham: "We are not cabbage farmers and nor do we want to be!"

Ever wondered what cabbage farmers and investment portfolio managers might have in common?

Much like a good investor, a farmer only grows crops that they think they can grow well whilst keeping a healthy crop rotation too. If, for example, the soil on their land is not right for growing cabbages - and neither do they have the tools or expertise to do so – then they don’t do it.

When a farmer across the river has a good year because the cabbage price is high, does the farmer who doesn’t grow cabbages really care? I think the answer to that should be ‘no’.

Similarly, I think as investors we have expertise and tools which make us better at picking certain stocks/sectors than others, i.e. stocks within our circle of competence. Over time we do try and grow that circle of competence as it would be ignorant not to do so. Having covered a variety of sectors, however, I would label the oil & gas sector as a cabbage. There are a lot of unknowns but what we do know is that many of the desirable business, financial and capital allocation traits we look for are not typically exhibited in these companies.

Do not grow cabbages just because your neighbour does

Structural growth is a tough gig

A structurally lower cost base is key

Capital allocation is equally important

Given the difficulty in growing your volumes/yield, successful farmers not only need to be good at growing their crops and the support of favourable commodity prices, but also need to be mavericks when it comes to reinvesting, i.e. invest counter cyclically.

Buying another farm when farmers’ incomes are low due to unforeseen commodity price headwinds is usually an astute strategy, albeit one that requires patience and a build-up of capital before the event.

Pre-2020, the oil companies were not hoarding capital but instead were levering up in order to feed unsustainable dividends. It is encouraging to see their dividends have since rebased to more sustainable levels, but I personally think the lack of counter cyclical investment is still one of the most disappointing observations when I look at the oil & gas sector. 2020 was a great opportunity to allocate capital for growth but their balance sheets would not allow it to happen, and instead pro cyclical retrenchment, positively correlated to the fall in the oil and gas price, ensued. I would welcome counter-cyclical investment in this sector.

In summary, for all of the above reasons we continue to avoid big oil.

To find out how the UK banking space has many comparable dynamics to the oil & gas sector read the full report here. In short, it covers:

• Valuation and inflation risks are not a 2021 thing. They are permanent fixtures when making an investment decision which is why we are sticking to our knitting in how we approach income investing.
• The VitalityInvest Ninety One UK Equity Income Fund will continue to avoid certain stocks or sectors which do not have the Quality attributes that we seek. As discussed in the piece, we happily avoid cabbages.
• We touch on some of the core attributes that we look for, ranging from structural growth potential, an efficient cost base and counter-cyclical capital allocation strategies, and explain why certain stocks within the banking and other commoditised sectors still do not meet this criteria.
• We continue to believe that UK equities look relatively attractive across the board and are cautiously optimistic of the forward return potential for the UK Equity Income Fund; many of our holdings have used the pandemic to strengthen their market positions, bringing lasting future benefits as opposed to temporary ones.