The portfolio delivered a negative absolute return over the first quarter. Performance was in line with the wider market; where global equities were broadly weaker in Q1.

UK listed miner Anglo American was the largest contributor to outperformance. The market reacted favourably to the business reporting excellent full year results, including the declaration of its highest dividend for a decade. Pre-tax profits rose to $5.5 billion and the business generated almost $5 billion of free cash flow while halving its net debt to $4.5 billion ($8.5 billion in 2016). Anglo American has been a real turnaround story since its dark days of 2015. The key drivers have been a heavy reduction in leverage and the disposal of non-productive, low margin assets. Capital spending is also still being constrained, with management stating they will only take on one project at a time. This is in stark contrast to the heady days of 2012-2014 where the business was ploughing billions into multiple projects at the end of the commodities boom. Spending on these projects sat at $2.2 billion in 2017 in comparison to $6.1 billion in 2013. We support this prudence and the continuation in the reduction of its debts. Those firms with less leverage will be better prepared to weather the storms should trade suffer in the future. We still see significant upside further upside for Anglo American from today's levels.

Intesa Sanpaolo also generated a robust gain. The company announced a solid set of Q4 results to round off what was a year of material progress for the bank. The latest results showed strong revenue growth, an improving trend in non-performing loans and strengthening balance sheet. Technicolor was the portfolio's weakest position over the quarter and we have elected to sell the position. Technicolor has made great strides in deleveraging the business but its debt burden remains considerable. This was previously accounted for by the extremely profitable tech arm of the business. However, with profit projections for tech now more conservative, our faith that the company can continue to service its debt has wavered. Debenhams was another of the largest detractors from returns in the quarter. The UK retailer's shares suffered as it communicated a post-Christmas profit warning due to difficult seasonal trading. While its balance sheet is currently viable, there is no doubt that Debenhams requires an improvement in sales to drive the share price higher.

A strong position was established in ENI, the Italian oil and gas business, in Q1. There was a general consensus that the firm has a strong balance sheet, after going through a process of de-gearing via a number of asset disposals which allowed the firm to pay down nearly €4 billion of debt in 2017. The business is also able to generate free cash flow to nearly entirely cover its dividend, despite the depressed price of oil. As value investors, balance sheet strength, prudent leverage and positive cash flow generation will always sit as positive points on our ledger; provided these coincide with an attractive valuation of course.
A new position has also been initiated in Taiwan through AsusTek Computer. It is a multinational computer and phone hardware and electronics company, offering an attractive 6% dividend yield. Profitability is fairly stable and it has an excellent track record of converting profits into cash flow with a noticeably solid balance sheet.
A new strategic alliance has also been conformed with Russian gas giant Gazprom. The business makes most of its profits in distribution, which is a relatively cost-light, asset-light sales division. We feel the balance sheet is sufficiently robust and note that Gazprom has a good track record of converting net income into cash. We are cognisant of potential political and corporate governance risks and so this will remain a modestly-sized position in the portfolio despite the significant upside to fair value.

Positions in Abercrombie & Fitch have subsequently been retied. The business itself is still cash generative, but the cost of store leasing is high and does not look sustainable over the longer term. As discussed in the performance note above, positions in Technicolor have also ceased.
- The portfolios areas of relative outperformance over the first quarter were characterised by not being typical 'bond proxy' businesses, which performed poorly.

- This should serve as a reminder that safety stems from the price you pay, and not the underlying dynamics of the businesses you buy. There are no equities that are always safe or always risky. There are only equities that are too cheap or too expensive. A business could have the most volatile earnings stream in the world but, if you buy it at a 90% discount to fair value, you are giving yourself a very good chance of making money from that investment.

- In the same way, you could identify the business that boasts the most stable earnings stream in history and yet, if you pay 10 times what it is worth, you are highly unlikely to make money. In fact you are more likely to end up losing money. To us, that is the definition of risk. It has nothing to do with the supposed predictability and stability of an asset - only the price you pay for it.

- What this means is that seemingly safe and stable businesses can become very dangerous investments as their valuations rise. It is our firm view that the downward share price moves of some of the so-called bond proxies in the first quarter were just the tip of the iceberg when it comes to the unwinding of market's love affair with those equities.

All investors take value into account to some degree; it is very rare to find an investor that is willing to buy a stock at any price. However, our approach is closely tied to the traditional definitions of value investing. That means investing in the cheapest part of the market, as defined by a metric such as price-to-book or price-to-cyclically-adjusted-profits. Value investing continues to work because it caters for all businesses that exist in the market that they are classified under. In addition to value investing, a strong analytical framework is employed to investment strategies so as to maximise growth potential over and above market uncertainty.

Changes in China's political, legal, and economic or tax policies could cause losses or higher costs for the fund. The counterparty to a derivative or other contractual agreement or synthetic financial product could become unable to honour its commitments to the fund, potentially creating a partial or total loss for the fund. The fund can be exposed to different currencies. Changes in foreign exchange rates could create losses. A derivative may not perform as expected, and may create losses greater than the cost of the derivative.
Emerging markets & frontier risk: Emerging markets, and especially frontier markets, generally carry greater political, legal, counterparty and operational risk. Equity risk: equity prices fluctuate daily, based on many factors including general, economic, industry or company news. Liquidity risk: In difficult market conditions, the fund may not be able to sell a security for full value or at all. This could affect performance and could cause the fund to defer or suspend redemptions of its shares. Operational risk: Failures at service providers could lead to disruptions of fund operations or losses. Shanghai-Hong Kong Stock Connect risk: The fund may be investing in China "A" shares via the Shanghai-Hong Kong Stock Connect which may involve clearing and settlement, regulatory, operational and counterparty risks.


Source: Schroder ISF Global Recovery quarterly fund update - First quarter 2018

The fund delivered positive absolute returns over the fourth quarter.

In the US retail sector we sold out of the fund’s position in US fashion retailer Guess? as the shares have performed reasonably well and the investment has made money for clients. However, since our initial investment the business decided to pursue a strategy of aggressive expansion and as a result the quality of its balance sheet has deteriorated. Over the summer of 2017, the Value Team undertook an intensive period of stock research in which all team members focused on the cheapest stocks in the world. As part of this we analysed 23 retailers in detail, and felt that while Guess? was cheap, there were more attractive risk adjusted opportunities on offer. As a result of this work, we established two new positions in the sector, Dillards and Buckle.

-Buckle is an American clothing retailer that has seen a significant fall in earnings over the past two years as it has expanded its store footprint. However, the company has historically operated with a higher margin and higher balance sheet quality than its peers. We believe the market overlooked these characteristics into the period of weakness. Since mid-October the stock has rallied sharply, but a considerable gap remains between the current share price and what we have determined as fair value for the business. Its 8% dividend yield also offers some valuation support (this includes a special dividend).
-Dillard’s is a family owned, US mall-based department store that has seen large revenue and profit falls over the past few years. However, while we assume hard times may continue, Dillard’s balance sheet and cash conversion are resilient enough to remain strong both independently and when compared with its peers. Although quality is low, we believe the stock’s very low valuation, and therefore significant potential upside, compensates for this risk.

Market volatility has been at low levels for an extended period. This poses a risk in that investors may take riskier decisions in the belief that the future will be as benign as the recent past. Low volatility also limits the number of new investment opportunities. However, this situation will not persist forever. We remain vigilant and are operating conservatively and prudently to preserve and grow our clients’ capital over the coming years.

-Technology group Intel supported fund performance over the quarter, with the latest quarterly results for the company well-received. Intel has performed very well in recent years as the market has come to reassess the widely-held view that incumbent hardware producers would struggle as usage rates of Cloud storage and processing increased. Our view is that even as the Cloud becomes a bigger part of data processing, consumers still need PC terminals, and businesses still require servers. Intel -one of the two largest semi-conductor makers in the world - is also a highly cash generative business.

-UK listed miner Anglo American continued to perform well. Over the past year or so the business has confounded market expectations to achieve significant improvements in productivity and efficiency and we support its strategy of further sales of inefficient, low margin assets. We wrote about this holding at length the previous quarterly fund update.

-Other positive contributors included US fashion retailer Abercrombie & Fitch and OPAP (Greek Organisation of Football Prognostics), which continued its recovery.

-UK retailer Debenhams’ was the largest individual detractor from returns in Q4. Its share price came under further pressure as sentiment towards the high street and clothing in particular became more negative. Given Debenhams’ low valuation, both in absolute terms and relative to its peers, there is considerable upside potential should its earnings recover towards the long-term average. While Debenhams has a reasonable balance sheet, its leases are significant financial liabilities. The potential upside compensates us for this risk, but we would like to see the new management do everything that it can to conserve cash.
-Italian bank UniCredit detracted from returns. The company held an investor day where it revealed that it expects new regulatory requirements to have a negative impact. While this unsettled the market, we are comfortable as the bank remains over-capitalised even allowing for these new requirements and revised up its dividend pay-out ratio for 2019. Unicredit continues to self-help and, given its lowly valuation, offers significant potential upside for investors willing to be longterm. Bridgepoint Education declined over the period, with litigation fears weighing as the California Attorney General filed a suit against one of its subsidiaries.

-Bridgepoint remains confident it will be vindicated of accusations that it pressures its institutions to fulfil enrolment quotas. Bridgepoint has a low valuation and net cash balance sheet. The regulatory risks that it faced in the past have considerably reduced, but the valuation remains depressed. We remain confident in the longer-term share price recovery.

Source: Schroder ISF Global Recovery quarterly fund update - Fourth quarter 2017