In 2009, they accounted for 30% of his fund and today that proportion is down to 4%. This has meant slashing exposure to popular areas such as housebuilders and travel companies.
‘Consumer cyclicals, being very early cycle, are less interesting to us. They have had massive reratings and done very well, but actually it is time to shift to later-cycle stocks,’ Hudson said.
‘We have really been shifting our portfolios away from some of the early-cycle cyclicals towards some of these more defensive assets.’
Hudson cites three examples of such opportunities. The first is catering company Compass, which is cyclical insofar as it benefits from a strong economy.
‘If there are more people employed in US factories because the economy is expanding, there are more mouths to feed and more money to make. So it has a cyclical element to it, but it also has a structural element as food services are being outsourced in increasing amounts.’
Hudson estimates 50% of the global market for feeding labour forces is now outsourced. He also points out that Compass exhibits defensive characteristics through the resilience of its earnings.
The fund manager supposes that if Compass made £100 million at the top of the cycle, at the bottom that might slip to £75 million, which would still keep the dividends flowing.
In contrast, he points out that if Rio Tinto made that same £100 million at the top, it would probably lose £100 million at the bottom.
He is also bullish on BT’s dividend growth prospects. ‘BT historically was seen as a utility. It didn’t have any growth, it had a high yield and it was very dull. Now it is trading just below a market yield, but it has fantastic dividend growth.
‘Over time the management has done a good job of taking costs out of the business and sorting out some of the balance sheet issues.’ He anticipates 12-14% dividend growth for the next couple of years.
Finally, he highlights Legal & General. ‘It was trading at a big discount to book value at the beginning of the cycle. It has rerated since that point, but they have been very good at driving cash flow and using that to drive dividend growth as well.’
The former Cazenove team has advocated business cycle investing for many years now, but doubters have questioned whether such a neat model can apply in a world of distorted monetary policy. However, Hudson says it is still relevant.
‘This is a practical and consistent way to think about running money. If you have ignored the business cycle, then at various points it will have potentially had some quite detrimental effects on your underlying portfolio.’
His own performance attests to that. The fund has returned 60.3% over the past three years, compared with an average 36.8% from the IMA UK Equity Income sector and a 31% rise by the FTSE All Share index. He ascribes half of those returns to the business cycle process and half to stock picking.
His strategy is informed by leading indicators of economic activity and sentiment, which he builds into a portfolio based on how stocks are positioned relative to what is coming.
‘What you’re really looking at is change factors: changes in consumer confidence or the new orders element of industrial production data. We’re not saying we know what the UK’s GDP will be next year, but you can see the direction of change. What unlocks it is looking at the valuation of companies relative to that change.’
‘At some point in the future these are the assets we’re going to want to own, but at the moment we find better opportunities elsewhere,’ Hudson said. He also stresses the importance of adhering to the business discipline.
‘For income managers in particular, it is easy to build a tail of assets where you end up with investments that may contribute to your income but not really to your active management.
‘I don’t want to have 4% of my clients’ money allocated to something I don’t really believe in. I would rather put them in the 50-60 ideas I really like.’