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IMPORTANT INFORMATION The views expressed in this article should not be considered as advice or a recommendation to buy, sell or hold a particular investment. The article contains information and opinion on investments that does not constitute independent investment research, and is therefore not subject to the protections afforded to independent research. Some of the views expressed are not necessarily those of Baillie Gifford. Investment markets and conditions can change rapidly, therefore the views expressed should not be taken as statements of fact nor should reliance be placed on them when making investment decisions. Baillie Gifford & Co Limited is authorised and regulated by the Financial Conduct Authority. A Key Information Document for Scottish Mortgage is available by visiting www.bailliegifford.com
Alexa, how big can you get?
When Scottish Mortgage’s Tom Slater met Jeff Bezos in Seattle recently, the Amazon CEO explained how little he cared about daily market news. Better, he said, to spend his time “living in the future … a wonderful place”.
The Amazon Echo speaker and Alexa, its integrated voice-activated assistant, are already everywhere. Cursory analysis might suggest that the smart speaker market is therefore maturing and the fastest revenue growth phase is behind us. According to this view, Alexa will be another contributor to a slowing top line at Amazon over the coming years. It is exactly this narrow kind of thinking that has led Wall Street to underestimate Amazon for the past two decades. We would not disagree that the smart speaker market is no longer of much interest. But far more importantly Amazon has laid the foundations of a new era of computing. Alexa’s success has created an expectation that we ought to be able to speak to our devices. The monitor, the keyboard and the mouse are too cumbersome to fit with our mobile lifestyles and consumers are embracing their alternative. With 28,000 Alexa-compatible smart home devices from more than 4,500 brands Alexa, is coming to your microwave, to your television, to your car, and even your bicycle. ‘Ambient computing’ is becoming a reality. The rise of this computing-on-the-go, where devices work in concert with our everyday activities, has been predicted for decades. Voice as the primary computing interface could reduce friction in communicating, searching, and most important to Amazon, buying stuff. Some readers may remember paging through a multi-volume encyclopaedia or even asking someone more informed to fill in knowledge gaps. Search engines made this task less laborious, although initially they were far from reliable. We needed to choose the right keyword, then navigate pages of search results hoping that the information sought would surface. Voice computing, on the other hand, requires and demands a more straightforward approach - the correct answer first time. As the pace of change in the computing era accelerates, we see new business models appearing, each with the ability to disrupt conventional methods. Voice has the potential to do that with search – whether seeking a piece of information or actively making a purchase.
Very few other companies have the infrastructure to create a product like Alexa. Amazon has over 100 million Alexa-enabled devices in circulation which means it is collecting data faster than rivals. Its competitive edge is increasing. Data matters because of how inadequate Alexa currently is relative to our expectations. We want to interact with ‘her’ like a person, where as in reality ‘she’ is a four-year-old algorithm. Those managing the business see themselves as a four-year-old start-up. The things they need to improve are predominantly engineering problems within their control. They need to improve their natural language processing and in ‘contextualised search’: the ability to give results based on user preferences and circumstances. According to results published in January, Alexa already boasts 80,000 skills. Amazon needs to connect Alexa to more devices, and to strike more partnership deals. As the future-dwelling Mr Bezos knows, these priorities have nothing to do with current market vagaries. Think of the potential: if this technology becomes our default household assistant and the means by which we organise our households, then Amazon has just taken an important step closer to influencing the way we decide to spend our money. And crucially, it can monetise this role by selling shoes, not just advertising shoes. This is a business model edge that no others can match. No wonder Jeff was so excited.
Tough questions are asked of advertisers as the intersection of computing and human language continues. The ‘real estate’ available to them reduces in a voice-driven economy and naturally, what remains becomes more valuable. As Alexa improves and the product becomes more widespread, advertisers will increasingly shift their attention to voice over text search. We may be seeing this already. Growth in ad revenues from Amazon’s ecommerce business show this area becoming a lucrative income stream for the company. Product advertisers already realise the importance of being one of Alexa’s coveted answers.
The value of your investment and any income from it can go down as well as up and as a result your capital may be at risk.
Alexa is coming to your microwave, your television, your car and even your bicycle
A strong company culture is often a source of competitive advantage. Gary Robinson, manager of the Baillie Gifford US Growth Trust, talks to Colin Donald about why it’s so important to ask companies about their culture.
What quality allows a company not just to survive the destruction of its bread and butter business model but to disrupt itself to become the market leader? According to Gary Robinson the answer is to be found in a company’s culture. This separates exceptional growth companies from average ones. For Robinson, cultural strength explains why Netflix, which started out as a DVD mail subscription service, is now the world’s largest content streaming provider. Conversely, cultural weakness explains why Kodak filed for bankruptcy in 2012 having fumbled for a decade to deal with the rise of digital photography. “The critical cultural determinant in Netflix’s case was the founder, Reed Hastings,” explains Robinson. “He had the moral authority necessary to allocate capital away from the larger, cash-generative DVD hire business and towards what at the time was a much smaller business, online streaming. “In order to do that you have to battle a lot of vested interests internally, because the weight of the organisation is still in the old business, along with the human and physical capital. It is vanishingly rare for chief executives to pull off something like that, and it’s entirely due to a founder-created culture.” Netflix is currently a top five holding in the Baillie Gifford US Growth Trust. Robinson regards spotting such rarities and backing them over five-to-ten years as one of the core strengths of Baillie Gifford’s low turnover style. As Robinson describes it, the quest for “true outliers” is largely down to understanding an “intangible” cultural quality in companies. Components include readiness to innovate and to engage employees at all levels of the company with a shared mission. “At the risk of oversimplifying, companies with distinctive cultures are generally those that are in it for the long term,” says Robinson. “Most companies in America aren’t run that way. They are run by corporate management teams incentivised for the short and medium term. They would rather buy back stock, boost their earnings-per-share, beat their bonus targets and collect their pay cheques than invest in projects with long-term timeframes and uncertain outcomes.
“We are looking for companies that behave in a different way, companies that think long term, that are willing to embrace risk, and willing to invest for the future. We then hold on to them for long periods of time to capture the potential upside inherent in their business models.” Candidate companies for inclusion in his portfolios are, he says, screened for the distinctiveness of their cultural attributes. The checklist of questions starts with: “What is the point of this company and what are its long-term ambitions? And secondly, does the company possess a significant culture and is this a source of competitive advantage?” Robinson expresses surprise that so few investors seem to care about culture, a reflection, he suggests, of the market’s bias to shorter timeframes. He recalls one CEO, Katrina Lake of Stitch Fix telling him that he was the only outside investor who had ever raised the issue with her. It is no coincidence that founder-led businesses such as Netflix, Amazon, Stitch Fix and Grubhub typically comprise around 70 per cent of the Baillie Gifford US Growth Trust’s holdings, while our research suggests they only account for around 25 per cent of the total US stock market. “Founders embrace risk, and as with Reed Hastings at Netflix, Katrina Lake at Stitch Fix or Jeff Bezos at Amazon, are willing to invest in the future at the expense of short-term profits,” Robinson adds. “They are able to navigate changing circumstances and unlock new growth opportunities that aren’t always apparent at the time of our initial investment.” Robinson notes that many managers seem ignorant of what corporate culture even means, confusing it with gimmicks or PR spin. “It’s not perks or crazy offices with slides from one floor to the next,” he says. “It’s about the shared values of the company and how it behaves. It’s about what the founders and the management teams say they want to do and how that relates to what they actually do over time. “Ambition, vision, determination, risk-seeking… the outputs of a strong culture are difficult to measure precisely. But just because something is hard to measure doesn’t mean that you shouldn’t try. In fact we would argue the opposite. When something is hard it presents an opportunity for us to add significant value by analysing it and spending time on it.” Robinson emphasises that a firm’s culture cannot be determined from presentations at broker- sponsored conferences, any more than it can from a balance sheet or a set of results. It takes shoe leather and air miles to distinguish good cultures from good spin. In the past Robinson has spent months in the US, burrowing into culturally compelling company stories in hot spots such as the Boston or San Francisco healthcare clusters. In addition, Baillie Gifford’s retained network of US researchers are well briefed on what cultural attributes to look for in up-and-coming unlisted companies. “The easier information is to find, the less valuable that information is,” Robinson says. Over the decades, Baillie Gifford’s quest for outperformance has sharpened its antennae for growth-oriented corporate cultures capable of defying Wall Street noise for long-term reward. The characteristics that the Baillie Gifford US Growth Trust shares with culturally compatible companies is a willingness to look very different from its peers, to challenge itself, to embrace uncertainty and to ride out cyclical volatility. It is, as Robinson phrases it, “really simple, but difficult to do”. This explains why companies with the right culture – and the investors who understand them best – tend to stand out from the crowd. SEAMLESS CULTURE Stand-out cultures tend to think differently on company structure and the role of technology. For Nasdaq-listed online personal styling company Stitch Fix, the attraction for Gary Robinson and colleagues is its rare integration of human and artificial intelligence (AI), in this case deployed to help those without the time or inclination to shop for clothes that suit their personal style and taste. Stitch Fix selects clothes for customers by using a combination of experienced stylists and machine learning that mines customers’ data to track their preferences and buying behaviour. The San Francisco-based company’s culture, according to Robinson, stems from its ability to incorporate and integrate new AI technologies into its platform. Its data scientists and fashion experts are given equal status at the company, based on common goals. And what’s more it has a chief algorithm officer – not many companies can lay claim to this.
Ambition, vision, determination, risk-seeking… the outputs of a strong culture are difficult to measure precisely. But just because something is hard to measure doesn’t mean that you shouldn’t try.
IMPORTANT INFORMATION Investments with exposure to overseas securities can be affected by changing stock market conditions and currency exchange rates. The trust’s risk could be increased by its investment in unlisted investments. These assets may be more difficult to buy or sell, so changes in their prices may be greater. For more details on the Scottish Mortgage Investment Trust, including the Key Information Document, please see our website at www.bailliegifford.com This article does not constitute, and is not subject to the protections afforded to, independent research. Baillie Gifford and its staff may have dealt in the investments concerned. The views expressed are those of Tom Slater, are not statements of fact, and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. If you are unsure whether an investment is right for you, please contact an authorised intermediary for advice. Baillie Gifford & Co Limited is authorised and regulated by the Financial Conduct Authority (FCA). The trust is listed on the London Stock Exchange and is not authorised or regulated by the Financial Conduct Authority.
A Question of Culture
If the entire UK stock market is undervalued – and against other international markets it is – then there will be other trusts in Law Debenture’s new sector worth backing
Take Law Debenture, which we review in our first feature, for example. While it would be an exaggeration to say the 129-year-old trust was ignored in the Association of Investment Companies’ Global sector, its switch to the UK Equity Income group is likely to raise its profile, pitting it against comparable UK focused funds and making its relative performance look more impressive. With the company’s new management looking to boost returns from its commercial businesses and fund managers James Henderson and Laura Foll hoping to ride a rerating of the UK stock market once Brexit uncertainty is cleared, prospects for this £693 million fund look attractive. Of course, if the entire UK stock market is undervalued – and against other international markets it is – then there will be other trusts in Law Debenture’s new sector worth backing, as our second feature on its fastest dividend growers demonstrates.
It’s not just domestic equities getting the cold shoulder from investors. Our last feature on five income bargains shows a variety of property and debt funds that are also out of favour and which are rewarding investors with good dividends while they wait for the word to spread. I can’t comment on income investing without mentioning fund manager Neil Woodford. The suspension of his Equity Income fund has outraged investors, even if latterly it had looked inevitable. One surprise has been that, despite the transparency of publishing all his holdings in the £3.5 billion fund, Woodford has nonetheless shocked the world with the extent of the illiquid unquoted and smaller companies he held in the portfolio. You could say Woodford was hiding in plain sight.
Hello, welcome to the summer issue of our e-zine. With the weather warming up there’s a theme of some investment trusts not basking in as much investor attention as perhaps they should.
Hidden in view
Brexit special issue
The political crisis over Europe shows no sign of abating and confusion over this country’s future course reigns supreme as we approach the 29 March deadline.
The UK stock market, which has relatively little connection with the domestic economy is cheap, dirt cheap, trading at a 30 per cent discount to global stock markets.
It’s an alarming and depressing predicament. However, amid all the Parliamentary votes and can kicking, one fact is clear for investors. The UK stock market, which has relatively little connection with the domestic economy is cheap, dirt cheap, trading at a 30 per cent discount to global stock markets and yielding comparatively more than government bonds than at any time in the past 100 years. Curiously, UK equity investment trusts are not cheap though. Unlike open-ended funds, where billions of pounds have been withdrawn over Brexit fears, shares in UK focused trusts have generally retained the same rating they had before the fateful European Union referendum in June 2016. Trust shares have not seen their discounts to net asset value widen, suggesting investment trust investors at least are not panicking. UK commercial property investment companies are under more pressure but even most of their shares have avoided the distressed prices you might have expected to see. Of course this could change in the weeks and months ahead. Crashing out of the EU without a deal remains an outside risk that could damage investment trust ratings and, meanwhile, the response of the pound is a complicating factor when assessing UK stock market prospects. Nevertheless, the calm exhibited so far suggests a level-headed approach is the best way to take advantage of an historic opportunity for investors to reweight back to the UK.
IMPORTANT INFORMATION Investments with exposure to overseas securities can be affected by changing stock market conditions and currency exchange rates. The views expressed in this article should not be considered as advice or a recommendation to buy, sell or hold a particular investment. The article contains information and opinion on investments that does not constitute independent investment research, and is therefore not subject to the protections afforded to independent research. Some of the views expressed are not necessarily those of Baillie Gifford. Investment markets and conditions can change rapidly, therefore the views expressed should not be taken as statements of fact nor should reliance be placed on them when making investment decisions. A Key Information Document is available by visiting www.bailliegifford.com
The Resilient Ones
To impress SAINTS’ managers it’s not enough to be a high-growth company or a solid payer of dividends. The trust’s joint manager Toby Ross talks about the search for companies built for bad times as well as good.
Cold Wars, real wars, trade wars, financial crises, oil shocks, downturns, tech bubbles: over four decades all have successively messed with financial markets. None has stopped the Scottish American Investment Company (SAINTS) achieving its goal of real dividend growth even in the most challenging times. The last time the trust cut its dividend was in 1938, when the world was on the brink of cataclysm. “The globe-spanning companies the trust invests in must provide investors with a dependable dividend income regardless of market adversity, while promising substantial future growth,” according to Toby Ross. He sums up this rare combination in a single word: resilience. SAINTS’ managers think very hard about the underlying characteristics of a business and how much it needs to invest capital to boost further growth. Companies free from this requirement can often find cash to pay dividends, even in hard times. Then there is the future growth trajectory. Can management look beyond current adversity with confidence that the business will be much larger in five or ten years’ time? Those that can are much more likely to stand by dividend commitments. SAINTS also likes management teams that take a very long-term view of the business, and which see sustaining a dividend as part of their bond with shareholders. “Some boards don’t see the dividend as a priority and when things get difficult it will be the first thing to be cut. Those businesses are unlikely to be a good fit for SAINTS,” Ross says.
Sonic has invested heavily in the fragmented but fast-growing global market for laboratory testing. This includes studying samples of tissue, blood and urine to determine the cause and nature of different cancers and other diseases. Over time, the combination of an ageing population and continued medical innovation mean that more of us are being tested for a wider range of conditions. Ross says that what makes Sonic stand out from its peers is long-standing CEO Colin Goldschmidt’s culture of ‘medical leadership’. When Ross met Goldschmidt in Sydney recently, he defined this culture as “doing the best for our patients [and] truly understanding what the doctor needs”. As well as strengthening its standing with clinicians, this philosophy has also made Sonic the go-to buyer for independent lab owners looking to secure a legacy for their business. Ross says that “Sonic’s business is very resilient to the ups and downs of the global economy. We think that this management team truly understands that what matters is the speed and accuracy with which they deliver to doctors and patients.” Another poster child of resilience from SAINTS’ broad range of holdings is C.H. Robinson, a Minnesota-based trucking broker that matches loads to be transported with available drivers through its Navisphere software platform. Access to the largest pool of customers and the largest pool of truckers allows it to provide a better service than rivals. It has few physical assets and does not require big capital expenditure for further growth. “If times get more difficult and revenues slow, that’s ok because the business doesn’t need big reinvestment to grow. The management’s commitment to maintaining and growing the dividend is really high, regardless of whether the margins this quarter are higher or lower,” Ross says. He also cites the commitment of C.H. Robinson management to pay out to shareholders from a sense of corporate duty. “They are very aware that there are lots of retired employees who live on these dividends. Management has been very clear that they would rather not grow the dividend too fast but make sure it’s resilient, to allow them to keep growing it even when business is slower.” Sustaining and improving on the trust’s long legacy of dividend growth, says Ross, is about “trying to understand what has made some companies resilient dividend payers even when things have got really hard”. The nuances can be subtle, but the reward is a portfolio dominated by companies in that sweet spot: able to bolster long-term growth and steadily increasing annual pay-outs to investors for the next four decades and beyond.
To illustrate the many forms that resilience can take, Ross cites two very different global businesses and markets from the trust’s holdings. The first is Sonic Healthcare, an Australian medical diagnostics company whose shares have been owned by SAINTS since 2014 and whose patience and vision excite the trust’s managers.
The value of an investment and any income from it is not guaranteed and may go down as well as up and as a result your capital may be at risk.
Source: Baillie Gifford & Co, data as at 31 December 2018
SAINTS total dividend per ordinary share (net) - pence per share
Past performance is not a guide to future returns.
Can management look beyond current adversity with confidence?
Extreme Returns
But occasionally direct assault has its virtues. This particularly applies to academic input. It can have the ability to stand outside the moment. It certainly has the ability to free itself from the preconceptions, self-interest and necessary operating dogma of practitioners and industry insiders. The very absence of skin in the game can be a virtue. Radical reappraisal is possible. Sometimes external authority gives the necessary evidence and context to build on uncomfortable and unexpected rumblings of our own. Such has been our experience of working with Hendrik Bessembinder of Arizona State University. In early 2017 Professor Bessembinder released his initial drafts of a paper titled Do Stocks Outperform Treasury Bills? The title itself is heretical. It is a central assumption of Modern Portfolio Theory that because equities are riskier they must have higher rewards. But Bessembinder showed that “slightly more than four out of every seven common stocks have lifetime buy-and-hold returns, inclusive of reinvested dividends, of less than those on one-month Treasuries. “When stated in terms of lifetime dollar wealth creation, the entire gain in the US stock market since 1926 is attributable to the best-performing 4 per cent of listed companies.” If this is right then our task is transformed. Our job is solely and simply to find and invest in the stocks that are capable of producing the extraordinary returns of the 4 per cent. So what characteristics might the companies need to produce these returns? What attributes in turn do we need to hope to identify them? As Bessembinder writes, “The returns to active stock selection can be very large. If the investor is either fortunate or skilled enough…”. So the natural course of affairs was for us to build a relationship with the Professor so that we could learn how to become skilled (or lucky). In March of 2018, James Anderson and Tom Slater, joint managers of Scottish Mortgage Investment Trust, travelled to Tempe, Arizona to discuss these matters with Professor Bessembinder.
“When stated in terms of lifetime dollar wealth creation, the entire gain in the US stock market since 1926 is attributable to the best-performing 4 per cent of listed companies.”
The two main areas of research that they agreed to work with the Professor on at this early stage are focussed on expanding data to the rest of the world, and trying to find common factors behind both the 4 per cent of the companies that have created all the return and the even more remarkable 90 companies (out of over 24,000) that have contributed half the wealth created in US equities since 1926. It’s this question of how to identify the qualities that have made these companies so successful, that has begun to unearth potentially crucial insight. It looks as if there could indeed be common factors behind the brilliance. Although many stocks with the most stellar returns now appear ex-growth (Exxon Mobil) or once mortally wounded but now surgically reassembled (General Motors), at the start of their lives they were all participants in markets that would become very large and they entered if, frequently, not first then at early stages (this has been the case from Exxon Mobil to Google). As these names indicate, titanic founder-owners, or at least missionary leaders, are the enduring pattern. An assemblage of FTSE 100 style companies boasting chief executives with three-year tenure does not feature. Moreover, these companies have not been run with slide rules or their ancient and modern equivalents. They are companies that acknowledge doubt and embrace emerging opportunities. Now in a sense much of this is predictable, even if it’s more acute and structural than James Anderson and Tom Slater surmised. What is more striking and even more exciting is the attributes that the Professor believes investors in their turn need to possess to identify the truly great potential companies. Just like the company founders themselves, he thinks the skills we need are centred on dreaming of a grand future, backing great people and coping with ups and downs. His explication seems to run very counter to the perceived market wisdom. It certainly casts doubt over the strong preferences of most investors for predictability and certainty. But still more his perceptions indicate that our job is much more about the imagination of the future and the qualitative assessment of leadership skills than about the hard analytic numbers and confident financial mastery. So the hope – or inspiration – that Professor Bessembinder provides to us is that as our financial industry marches firmly and unanimously up one hill, we should be running determinedly in the opposite direction. If we are right that is a compelling competitive advantage. But there’s one last essential to the Professor’s current thinking. Identifying the great investments isn’t enough. As Hendrik Bessembinder makes plain it is the long-term compounding of their share prices that matters. This seems to us to require an additional set of skills such as the creativity to imagine greatness discussed above. The compelling urge amongst ordinary humans for sure, but far more damagingly amongst that odd sub-breed that are fund managers, is to take profits and lock in performance. As the old saying goes: ‘it’s never wrong to take a profit’. We believe it is often not just wrong but the worst mistake that can be made.
At Baillie Gifford, we generally prefer our research to appear irrelevant. The further it is from being a direct debate about the merits of a company as an investment, the happier we tend to be. Much of the most valuable research is deeply indirect in its investment implications and surprising in its eventual impact.
Check out our website – citywire.co.uk/investment-trust-insider – for your daily dose of news, interviews and comment on your favourite investment funds.
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Brexit Meltdown: are property trusts better than funds?
Yes was the short answer in a debate by a panel of experts looking at the best way for investors to access bricks and mortar in light of Brexit and the wave of property fund suspensions over two years ago.
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Key Points:
Law Debenture is celebrating its 130th year with a move to the UK Equity Income sector where its largely UK investment portfolio is a better fit.
Although a good long-term performer the investment trust has until now been overshadowed in the Global sector.
Unusually the £720 million company runs an independent professional services business alongside its investments.
The Association of Investment Companies’ UK Equity Income investment trust sector, where many investors go in search of listed funds with good dividends and total returns, has an exciting new entrant. It is Law Debenture Corporation (LWDB), which is a surprise for an investment trust celebrating its 130th birthday this year! Law Debenture is something of an oddity even in the investment trust world where strange names and long histories are common place. Launched in 1889, when Queen Victoria still had eleven years to go in her long reign, Law Debenture’s name is derived from its original business as a specialist trustee for bond investors. A debenture is a form of secured loan, similar to a mortgage, and ‘law’ reflected the fact its early backers were the City legal firms with which it worked. Today the £720 million company still operates a thriving independent professional services (IPS) business that now encompasses its role as a trustee to the pension schemes of blue-chip firms, and also providing a ‘whistle-blowing’ facility for workers with information about possible serious misdemeanours by their employers. The IPS business constitutes around 14% of Law Debenture and is an important part of its investment story. However, the company is best known for the investment portfolio of 140 mostly UK stocks run by James Henderson and Laura Foll at Janus Henderson, which accounts for the rest of its assets.
This is a good time to appraise Law Debenture because last month it moved from the AIC Global sector where for a long time it had looked out of place with at least 70% of its assets invested in the UK. Not only was Law Debenture an anomaly alongside the more internationally diversified funds in the Global sector, it also lay buried near the bottom of the performance rankings as its returns faltered in the woes of the post-Brexit referendum UK stock market. The switch to UK Equity Income has remedied this. Now, at a stroke, not only can investors compare Law Debenture with its true rivals, they can also see its relative performance has been transformed. Whereas before Law Debenture chugged along near the bottom of the Global sector for its long-term returns, as I write, it now finds itself in sixth out of 25 UK equity income trusts. As our main table shows, a near 265% total shareholder return over the past 10 years looks good in a sector where the average return has been 245% and excellent against the broad UK stock market with a FTSE All-Share index advance of 153%. Admittedly, this performance is completely outgunned by the sector’s big leader, Finsbury Growth & Income (FGT), which in the past decade has delivered an impressive 483% return from Nick Train’s concentrated portfolio of largely global consumer brands. Chelverton UK Growth (SDV) also deserves a mention for beating Finsbury with a 500% return. However, the small, higher-risk split capital trust is a volatile performer whose shares have slumped 25% in the past year and may not suit an income investor looking for slightly steadier returns.
Good out of Global
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‘WOULD IT BE ACCEPTABLE TO USE SCOTTISH MPs TO NATIONALISE AN ENGLISH UTILITY?’ JAMES HENDERSON ON SEVERN TRENT
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While Finsbury naturally commands investor attention, with Train nowadays frequently reminding investors that his long run of good returns won’t last, it is worth considering what other trusts are available in this core sector. This is where the analysis gets interesting. In terms of its total returns, Law Debenture can hold up its head against the sector’s other leading funds, such as City of London (CTY) which has generated 209% over 10 years, and JPMorgan Claverhouse (JCH), up 195% over the same period. Lowland (LWI), another UK equity income trust which Henderson and Foll also manage at Janus Henderson, has done slightly better, however, with a 269% total return. A more focused and UK oriented portfolio, this conventional £370 million investment trust does not have the equivalent of an IPS business on its side. Moreover, it has a higher dividend yield of 4.3% and has grown dividends by 10% a year on average in the past 10 years, the best in the sector. By contrast, Law Debenture yields 3.1% – below the sector average of 3.9% – and has grown pay-outs by just 3.8% a year, again below the peer group average of 4.4%. Although it has not cut its dividend for 40 years it does not make the AIC’s Dividend Heroes list for growing shareholder pay-outs for more than 20 years.
Dividend hero?
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But what the past performance data doesn’t tell you is that Law Debenture is a giant waking up after a long slumber.
New brooms
Law Debenture: a giant wakes in UK Equity Income
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Laura Foll tilting towards higher-yielding FTSE 100 stocks
In the past two years, there has been a clear-out at the top of the organisation with a new chairman, chief executive and chief financial officer arriving to shake up the IPS business and improve its profitability. Early signs are encouraging with the company reporting revenue growth of 9% last year. Meanwhile, after a difficult period for the fund managers, whose ‘value’ investment style has been out of favour, Henderson and Foll have got the bit between their teeth investing £50 million since the market lows in December after the nasty sell-off in the fourth quarter of last year. Of this, £34 million has been invested in 2019 by deploying Law Debenture’s gearing – or borrowing – into a UK stock market they believed was far too cheap. They have opened new positions in Royal Bank of Scotland and Direct Line and added to their holdings in specialist income-producing investment trusts.
If both sides, the IPS business and the investment portfolio, start to deliver, Henderson told me dividend growth could soon reach 10% a year, matching Lowland and improving yields and total returns to shareholders in the process. With its shares trading at a near 8% discount below their net asset value, Law Debenture could be the one to watch.
Law Debenture moves into top 10 of UK Equity Income
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Chief executive Denis Jackson is passionate about the ‘wonderful’ IPS businesses he took responsibility for at the start of last year. Having joined Law Debenture in 2017 from Capita, the outsourcing company, where he headed new business enterprise, Jackson is proud of the strong reputation Law Debenture has earned over the years in its corporate, pension and bond services businesses. However, he turns to cricket, a game he loves, for an analogy of how Law Debenture needs to strike the right balance as it strives to become more outward looking, competitive and fairer to its shareholders.
‘If you look at the score board all the time you get bowled out – but if you never look you won’t win the game,’ he declared about his ambitions to increase IPS profits, which until last year had been flat for six years. Speaking in Law Debenture’s office in the City of London, Jackson said his challenge was to preserve the company’s customer service culture while expanding the business beyond its existing niches in order to improve accountability and returns to shareholders. ‘This is not about growing margins – but if we can maintain margins and grow revenues that would be great,’ he said. Overseeing this project is chairman Robert Hingley, a former investment banker and head of investment at the Association of British Insurers, who also chairs Berlin residential property fund Phoenix Spree Deutschland (PSDL). Writing in the latest annual report, Hingley, who joined the board after Jackson’s arrival and became chairman in April last year, endorsed his chief executive’s ‘ambitions to achieve mid-to-high single digit growth in 2019’.
And helping Jackson on investor relations and improving the reporting of IPS’ commercial performance is Katie Thorpe, the new chief financial officer, who last year joined from RIT Capital Partners (RCP), the popular Rothschild family backed global investment trust.
Eye on the score board
‘If you look at the score board all the time you get bowled out – but if you never look you won’t win the game.’ Denis Jackson, Law Debenture
Chief executive Denis Jackson talks about his plans to improve returns from the IPS operation.
Fund manager James Henderson explains why long-term prospects income and capital growth are looking up.
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The great advantage of Law Debenture’s hybrid structure is that the minority IPS business punches above its weight in dividend terms, generating 40% of the income that flows to shareholders. There is a double benefit from this: potentially bigger dividends but also increased flexibility for the fund managers who don’t have to chase high-yield stocks as much as they might otherwise do. Henderson and Foll can also back fast-growing businesses that could become big dividend payers in future.
It’s a significant asset to have when the trust’s objective is to ‘achieve long-term capital growth in real terms and steadily increasing income’ and beat the total return of the FTSE All-Share index. The trouble is IPS earnings per share didn’t grow between 2011 and 2017, which combined with the fund managers struggling in a growth-obsessed stock market, meant a slow-growing dividend. Fortunately, Law Debenture has built up revenue reserves of nearly £50 million, enough to cover over two years of dividends. That means a dividend cut is not an immediate risk. Nevertheless, Jackson is keen to do better on the objective of delivering rising income.
‘It’s really important that James and Laura do that and that we do,’ he said.
Dividend support
Katie Thorpe: chief financial officer joined last year
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On his side of the fence, Jackson has focused on two aspects: cutting costs by making his business managers more accountable for their budgets and ‘trying to be more transparent what the levers of profitability are’; and improving communication between the different teams with the aim of increasing cross-selling across their client lists. The attraction of growing both the corporate trust division – which covers the original corporate bonds business – and the corporate services side – which services the rapidly expanding market in asset-backed securitisations – is that they involve long-term contracts, administering the bonds for 20, 30 or 40 years until they mature. These are essentially stable businesses in which Law Debenture gets paid retainers for serving as a conduit between a bond issuer and bond holders. The beauty of this is that much of the revenues are booked in at the start of each year. Moreover, the income is often inflation linked, further underpinning the resilience of Law Debenture’s dividend. However, the earnings can be volatile. While fees will rise when things go wrong with a bond and Law Debenture has more work to do in protecting investors, so can costs. Jackson and Thorpe wish to say more about these risks and rewards as they improve disclosure to shareholders.
Long contracts
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Jackson also plans to say more in future about Safecall, the Sunderland-based whistle-blowing unit that nestles in corporate services. He has great hopes for a business which he said was well placed to grow as government and regulators recognise more help is needed for individuals ringing alarm bells when things go wrong. Unlike its private-equity backed rivals, which he says operate from call centres, Safecall was founded by a former police officer and employs full-time, dedicated staff. He said this was important given the gravity of the situations in which callers can find themselves. ‘People ring in fear of their jobs or even their lives. The Safecall staff are very good at taking notes and preparing the case and reporting it, usually to the senior non-executive director on a company’s board.’
Safecall
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It is fair to say some investors may have wanted to ring alarm bells over the stock upsets Henderson and Foll have experienced in the past two years. Henderson, who has been involved with the portfolio since 1994 and been its lead manager for 16 years, is a committed, contrarian value investor, looking to buy stocks when they are cheap and unfashionable. As he readily admits this can lead him into bad stocks on occasion.
The pitfalls appear to have become more regular of late with the duo caught out by the collapse of contractors Carillion and Interserve, off-licence chain Conviviality as well as the severe problems at lender Provident Financial, which hit many investors, including rival equity income managers Mark Barnett and Neil Woodford. In December he added Kier to the portfolio after the construction group struggled to raise £250 million in an emergency rights issue. Henderson believed that as one of the last companies standing in its sector and with its balance sheet restored, it could do well. Unfortunately, there has been no let-up in the financial pressure and a 0.9% position bought at what at the time seemed a lowly £3.60 has more than halved this year. In his defence, Henderson points out that the long tail of holdings in the trust reduce the impact of individual
stocks going wrong. And there has been a better return on Severn Trent, one of the larger additions made last year, with a 1.2% weighting in December, which was bought when its shares were depressed by fears of tougher regulation and possible nationalisation by a future Labour government. The 5% yielder is up 10% so far this year. Henderson played down the threat to the English water company from Labour. ‘I think they’ll put up a really good fight. This has been a really good denationalisation,’ he says, arguing the quoted company has done a better job on investment in its infrastructure than unquoted rivals such as Thames Water. He also doubted if a Labour government could push a nationalisation of Severn through Parliament with the help of Scottish MPs, ‘Would it be acceptable to use Scottish MPs to nationalise an English utility?’ he asked, when English MPs would be unable to do the reverse.
No cheer at Kier
Law Debenture launched towards the end of Queen Victoria’s reign
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Despite the mishaps, more things have gone right than wrong in the portfolio. Although net asset value fell 5.8% last year this was better than the 9.5% decline in the FTSE All Share and the trust remains ahead of the benchmark over three, five and ten years. Henderson cites two areas where the income from the IPS businesses has helped. Firstly, unlike many equity income funds, the managers have shunned tobacco stocks, fearing their cash generative powers masked an industry in decline, and have avoided the sharp fall in British American Tobacco. Similarly, they felt comfortable a few years ago buying depressed mining stocks, even though they didn’t pay good dividends, and enjoyed their rebound, although Henderson admits they took their profits a bit early. Henderson describes Law Debenture as a ‘one-stop shop’ for investors looking for income and growth without too much risk, with a largely UK portfolio topped up with some overseas exposure, such as its successful, long-term holding in Microsoft, the US software giant for which he said there was no equivalent on the London Stock Exchange. The trust is currently 76% invested in the UK and will have to raise this to at least 80% to comply with its new sector requirements. This is likely to be done by selling its stakes in the Baillie Gifford Pacific and Stewart Investors Pacific funds.
One-stop shop
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He joked that if investors did want another trust they could buy Lowland as well. The serious point he makes is over Brexit. With only 27% of its portfolio companies’ revenues generated in the UK, Law Debenture is well positioned if there is a ‘hard’ no-deal divorce from the European Union. By contrast, Lowland, with 50% of UK revenues, will do better if a managed withdrawal is agreed, minimising the impact on the UK economy.
Foll, who joined Henderson on Law Debenture in 2013, said it wasn’t just them who thought the UK market was cheap. The ongoing spate of mergers and acquisitions with overseas bids for Manx Telecom and Dairy Crest this year and the recent bid approach by Londonmetric for rival property company A&J Mucklow, showed others saw a long-term buying opportunity as well. She said the pair had used the £34 million of Law Debenture’s borrowings to ‘tilt’ the portfolio towards higher-yielding stocks in the FTSE 100, such as RBS, where they saw more value, encouraged by the relatively encouraging state of the UK economy. As a result gearing - the proportion of debt to net asset value - has risen from 3% to 12%.
Bad Brexit
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Henderson, whose family own 100,000 shares in Law Debenture, is a fan of investment trusts, which fits a manager running three closed-end funds (in addition to Law Debenture and Lowland he also manages Henderson Opportunities Trust (HOT)). He quotes Law Debenture’s former chairman, Douglas McDougall, who told him: ‘Don’t be proud if someone is doing something better than you’ to explain his holdings in Scottish Oriental Smaller Companies (SST) under Vinay Agarwal at First State Investments, and Herald (HRI), the UK technology trust managed by Katie Potts. More recently, he has focused on trusts providing alternative, non-equity sources of income, adding to small positions in Foresight Solar Fund (FSFL), Urban Logistics (SHED) real estate investment trust and Hipgnosis (SONG), the music royalties fund, and making a new investment in African commercial property fund GRIT Real Estate Income (GR1T). But what excites Henderson is the possibility that Law Debenture will now be seen in a new light in the UK Equity Income sector. Since the company confirmed a 9.2% rise in annual dividends to 18.9p per share in March - which was double the average increase of the past 10 years - the shares have narrowed their discount from 13% to under 8%. He believes this re-rating could continue if Denis Jackson hits his objectives at IPS and he and Foll deliver 5-6% earnings growth on the investment portfolio. This could pave the way for similar dividend increases in future, he said. ‘For retail investors it’s quite a safe dividend story,’ Henderson said.
Buying trusts
Deal or no deal: where the pros are placing their bets
It is the uncertainty over Brexit and what arrangements the UK will have with Europe after 29 March that has unsettled the pound and UK stock market, not the economic impact of leaving the European Union.
While a ‘hard’ Brexit will deliver the greatest economic harm in the short term, most experts believe any kind of certainty established after 29 March could pave the wave for a further rebound in UK shares, given their current depressed levels.
We asked professional investment trust investors to pick their favourites for a recovery as well as those trusts that might offer a safe haven from further stock market turbulence.
See our list of UK investment trusts hoping for a Brexit bounce
UK trust discounts not that pronounced
Law Debenture moves into top 10 of UK Equity Income sector ranked by 10-year shareholder returns
As a follow-up to our first feature on Law Debenture, we look at five other investment trusts in the UK Equity Income sector that have generated good growth in their dividends in the past five years.
The result is an interesting mix of three trusts - Lowland, Aberdeen Standard Equity Income - that have struggled with the Brexit cloud hanging over their investments in the past three years but which may do better once the uncertainty over the UK’s departure from the European Union is resolved. In the meantime they are paying good, rising dividends to shareholders.
The list also includes two stronger performing trusts, Finsbury Growth & Income and JPMorgan Claverhouse, which have generated stronger returns while lifting payouts to investors.
Law Debenture’s arrival in the UK Equity Income sector (see previous feature) and its ambition to grow dividends by up to 10% a year lays down a challenge for its new rivals. High yields are good if you need a lot of income today, but many long-term investors would prefer a lower starting yield and strong dividend growth. That’s because a healthily rising dividend will beat inflation and provide more income in the future. It will also power total returns as a growing dividend will generally be accompanied by an advancing share price. So which are the UK equity income trusts with the fastest growing dividends to support future income and growth? Here are the top five according to data from the Association of Investment Companies (AIC).
Lowland’s chairman Robert Robertson defends its performance
Five more challengers for UK dividend growth
Thomas Moore: ‘rich seam’ of opportunities
As a result, underlying growth in net asset value (NAV) of 18.9% in the past five years looks poor and lags the 32% total return of the FTSE All-Share index by some way. Meanwhile, the actual total return received by shareholders has been just 12.5% with the shares standing on a 5% discount below NAV. The trust’s board does not seek to control the discount with share buybacks, believing these are ineffective. In its recent half-year results to the end of March, the trust’s chairman Robert Robertson backed the managers saying their contrarian, value approach of buying cheap and out-of-favour companies did produce periods of underperformance. ‘Over the longer term, performance has been strong, with an increase in NAV (total return) of 380% over the last ten years, against 187% in our benchmark,’ he said.
Moore takes a ‘multi-cap’ approach, combining smaller and medium-sized companies alongside the FTSE giants. For example, construction services group John Laing took 5% of its assets at the end of April compared to 3.8% in Royal Dutch Shell. This is a more concentrated portfolio than Lowland, holding between 50-70 stocks, although Moore is barred from putting more than half of the trust in his top 10 positions. Nearly half of its assets are in financial stocks, however. Alongside HSBC bank and insurers Aviva and Prudential, Moore likes fund managers Premier and Close Brothers.
Swings in performance as a result of focusing on unfashionable areas of the UK market and deviating from the classic big income stocks of the FTSE 100, is something with which fund manager Thomas Moore is also familiar. His £202 million Aberdeen Standard Equity Income trust has done better than Lowland over the past five years. Nevertheless, an underlying total return in net asset value of 23% and a total return to shareholders, including dividends, of nearly 16% also looks modest against its sector and the FTSE All-Share. Arguably, investors are being paid to wait here too. Those dividends have grown by an average of 7.6% in the past five years to place it second in the AIC’s list of dividend growers. At the current share price it offers a high yield of 5% and holds £10.8 million in revenue reserves, providing cover equal to one year of dividends.
Aberdeen Standard Equity Income (ASEI)
Moore says the ‘bifurcation’ between fully-valued and over-sold stocks is extreme and has left the portfolio at its cheapest level since 2009 after the financial crisis. However, he says it creates a ‘rich seam’ of opportunities. The fund manager argues that when the dust finally settles on US-China trade war and Brexit concerns, the group of misunderstood stocks will experience a ‘woosh moment’. As evidence of this he cites housebuilder Galliford Try (GFRD), a 2% position whose shares until recently traded on a dividend yield of 12% and four times forecast earnings. This ‘mispricing’ was spotted by rival Bovis which offered to bid for its housing businesses, although it was swiftly rebuffed. Moore said Bovis’ offer was an example where ‘if the stock market is not willing to rate [a company] at a sensible valuation then a corporate will’.
Third-placed JPMorgan Claverhouse offers an interesting compromise, combining good average annual dividend growth of 7.2% in the past five years, a 4% yield and a more ’benchmark aware’ approach that has helped recent performance. Unlike their counterparts on Lowland or Aberdeen Standard Equity Income, Claverhouse fund managers William Meadon and Callum Abbott are guided by what’s in the FTSE All-Share, overweighting or underweighting stocks they like or dislike, but not shunning them altogether if they are a big part of the index. ‘Even if we don’t like a stock, if it’s very big, like British American Tobacco, we will hold it so that even if we’re wrong and we’re always conscious we could be with any individual stock, but if we are wrong, it doesn’t knock the whole portfolio off course,’ he said. Just under 3% of the £396 million trust is in the stock.
JPMorgan Claverhouse (JCH)
Top five dividend growers among UK Equity Income investment trusts
Lowland (LWI)
It’s probably no coincidence that Law Debenture fund manager James Henderson estimated its annual dividend growth rate could reach about 10% if its professional services businesses start firing on all cylinders. That is what it will take to beat Henderson’s other investment trust in the UK Equity Income sector. The AIC dividend growth figures are based over five years but in fact Lowland Investment Company has grown its main dividend by 10% on average for seven years and tops the 24-strong peer group (see table). It also has revenue reserves of £15.5 million, equal to one year’s dividends, to support future payouts.
In addition the £373 million investment trust offers an attractive dividend yield of 4.3%, although this partly reflects a difficult time for the 116-stock portfolio, whose smaller company holdings under Henderson and co-manager Laura Foll have struggled in the post-Brexit referendum market. Its overweight in industrial stocks, such as engineer Senior, backed by the managers for its good long-term prospects from civil aerospace, have suffered from evidence of a global slowdown and fears of the trade tensions between the US and China.
William Meadon: ‘get rich slow’
BATS shares have had a tough time in the past two years but that hasn’t hurt Claverhouse’s overall returns. Over five years its net asset value has grown by 38.7%, beating the UK index and underpinning a total of 42.1% to shareholders. ‘I call it a get-rich-slow fund - we’re just trying to get our clients to where they want to get to with their financial goals without it being too volatile along the way,’ Meadon said. The dividends Meadon and Abbott deliver are backed by substantial revenue reserves of nearly £24 million, equivalent to 1.5 years of pay-outs.
Meadon said the ability of investment trusts to put away up to 15% of investment income every year and call upon these reserves when needed was a huge advantage given the outlook for UK dividends was deteriorating after a strong run. The decision by Vodafone to cut its dividend showed that some high yields in the UK were more ‘apparent than real’ and would be likely followed by others, he said. ‘If income in the UK market is flat, or dare I say, goes down this year, open-ended income funds will reflect that in their distribution this year as well and shareholders will suffer,’ Meadon warned. ‘But in investment trusts, which have strong reserves, investors who depend upon income have a much more secure and safe position in terms of visibility of their income flow.’
‘Train is an aficionado of the Warren Buffet school of analysis,’ says Brewin Dolphin fund analyst Michael Paul. ‘The focus on sustainable business franchises and brands has produced exceptional long-term total returns.’ Perhaps not surprisingly, Finsbury Growth & Income has amassed solid revenue reserves of £37 million. This means it could pay 1.25 years of dividends even if it didn’t receive a penny from its investments. Despite its success, the shares do not trade on a lofty premium. A steady issuance of new shares means the trust’s stock tends to stand close to their underlying net asset value.
Critics and rivals say these are too expensive but Train disagrees. He has consistently argued that while constant vigilance is required on his part, the ongoing successes of Diageo, Unilever, Mondelez and Heineken show they are not ‘perilously expensive’. And the global appeal of brands such as Tanqueray gin, Dove soap, Oreo biscuits and Heineken lager powers not only the profits of their corporate owners, it also underpins growth in the trust’s dividends, which have risen an annual average of just over 6% in the past five years.
Nick Train is often referred to as a ‘star’ fund manager for his record on Finsbury Growth & Income. While that label has been tarnished by the decline in Neil Woodford’s fortunes, there is no denying Train’s achievement on the £1.8 billion investment trust which he has run for 19 years. By focusing on a relatively narrow group of strong businesses Train believes have enduring global brands the manager has generated a sector-leading 493% total return in the past 10 years. Over five years shareholders have received a total return of 88.6%. The trust’s comparatively low yield of 1.7% is frequently cited as testament to its strong share price performance. It also points to the wider debate over the valuation of the consumer stocks Train holds in the concentrated portfolio.
Finsbury Growth & Income (FGT)
Nick Train, Lindsell Train
From the biggest trust in the sector we end with one of the smallest. Chelverton’s minnow-like £37 million market valuation is at odds with its impressive long-term performance. Over 10 years it lies second to Finsbury Growth & Income with a total return to shareholders of 458%. However, it does suit its focus on a large number of smaller companies, where fund manager David Horner and David Taylor invest in stocks with starting yields of 4% where they believe the dividends are secure. Over five years, however, the returns of 26.5% have been far more moderate. In part this is due to the Brexit cloud hanging over all trusts with a bias to smaller UK and domestic stocks. Fear of getting stuck in an illiquid trust with hard-to-sell holdings has seen Chelverton’s share price drop 25% in the past year.
On an 11% discount to net asset value, the shares offer value to income investors prepared to see the value of their holdings rise and fall.
The volatility is also compounded by its ‘split capital’ structure. The company has two classes of shares: ordinary income shares and zero dividend preference shares which receive no income but are first in the queue to get a pre-set level of capital growth. In effect, the ordinary shares ‘borrow’ dividends from the zero shareholders. This shows up in the high level of gearing - or borrowing - of 34% (see table) which some investors find off-putting. However, it also contributes to its high 5% yield and average annual growth of 6.1% in its dividend over five years.
Chelverton UK Dividend (SDV)
Chelverton’s David Horner starts by looking for stocks yielding 4%
UK commercial property trusts: three-year returns and dividend yields
We highlight five investment trusts yielding good levels of income whose shares look cheap, either trading at a discount below the value of their assets or lower than their price range of the past year.
Although not without risks, the investment trusts we have picked invest in a range of income-producing assets and markets, from UK equities, to property and debt.
They are Law Debenture, which we looked at in our first feature, Real Estate Investors, Civitas Social Housing, VPC Specialty Lending Investments and Biopharma Credit.
Increasing the level of dividends to shareholders has proved an effective way for investment trusts to attract investors in recent years. A growing number of investment trusts have successfully re-rated – and narrowed or eliminated the discount at which their shares trade below asset value – by raising the yield they offer. Nevertheless, there are some investment trusts that even though they present good yields, trade on relatively lowly valuations. We pick five.
‘the unique characteristics of the structure and relatively conservative accounting principles make this an excellent long-term, low-cost investment.’ Peter Walls, Unicorn Asset Management
Size: £720m Annual ongoing charge: 0.45% Yield: 3.2% (semi-annual dividends) Discount to net asset value: 10%
Law Debenture (LWDB)
Five trust bargains for income
We’ve devoted an entire feature to Law Debenture already and include it as our first trust bargain because there are three factors that could combine to push the shares higher and narrow their discount to net asset value (NAV) which has recently widened to 10%. This looks wide compared to the 5% average discount of UK equity income trusts. Firstly, its move from the Association of Investment Companies’ Global sector to the UK Equity Income grouping raises its profile with income investors and makes its long-term performance – sixth out of 25 trusts in its new peer group with a 265% total return over 10 years up to 11 June – more impressive. This beats the sector average 245% return and the 153% growth in the FTSE All-Share index over that period.
Global investment trust opportunities
Secondly, the independent professional services (IPS) businesses that account for 14% of its assets and 40% of its dividend, are under an ambitious new chief executive, Denis Jackson, who is seeking to grow the profits that Law Debenture generates for shareholders. Thirdly, James Henderson and Laura Foll, the fund managers running its 140-stock portfolio, have recently ramped up their investment in a UK stock market they believe to be cheap after a three-year Brexit freeze. Although their ‘value’ investment style has been out of favour, there is hope of a recovery if the UK’s vexed departure from Europe is resolved one way or another. Henderson believes the trust is a good bet for a ‘hard’, no-deal Brexit because the companies it holds generate just over a quarter of their revenues in the UK. Peter Hewitt, who holds 3.6% of the BMO Managed Portfolio Income (BMPI) he manages in Law Debenture, its biggest position, said: ‘Income growth picked up to 9% last year, from around the 3% level over the previous two years. I am hoping for mid-to-high single digits over the medium term. The absolute dividend yield is at 3.2% towards the low end for the sector but growth prospects are better than most in the sector.’ He added: ‘The discount of 10% is too wide and I believe could narrow as the growth prospects of IPS are better appreciated, however, it may take the cloud of Brexit to be removed from the UK market before that happens.’ Peter Walls, manager of the Unicorn Mastertrust fund, is also a long-term holder with a 2.3% top-10 weighting. He said: ‘I continue to hold the share as the unique characteristics of the structure and relatively conservative accounting principles make this an excellent long-term, low-cost investment. While further dividend growth will be helpful, a greater determinant of the discount level in the medium term will be the performance of and sentiment towards the UK equity market in my view.’
Size: £102m Annual ongoing charge: N/A Yield: 6.7% (quarterly dividends) Discount to net asset value: 21%
Real Estate Investors is run by Paul Bassi, a property entrepreneur who owns 5.5% of the shares. Invesco owns nearly 22%, much of it held in Mark Barnett’s Perpetual Income & Growth (PLI) investment trust and Invesco UK Strategic Income fund. Bassi has a good track record of using his local knowledge and contacts to buy properties cheaply, refurbish them or change their use and increase their sale and rental value. Last year the AIM-listed company spent £15.4 million on new buildings on a high initial rental yield of 8.9% which indicates the good prices at which it was buying assets. This lifted the overall portfolio, including debt, to £225 million with 269 occupiers, 96.1% occupancy and £17 million of rental income, up 4.9% on 2017. The biggest chunk of the portfolio - nearly 38% - was in offices at the end of 2018, followed by 26% in retail mostly in convenience, value and neighbourhood outlets, which the company said were continuing to perform well but were undervalued due to the current negative sentiment to retailing. There were smaller allocations to medical centres and pharmacies and restaurants, bars and coffee shops. Bassi and chairman John Crabtree were untroubled by the retail downturn or the threat of a hard Brexit. ‘Many see the present environment as challenging and troublesome. We do not. As a management team we have operated in uncertain times before, the 1990s recession, the 2008 financial crisis, the Scottish and European referendums, and each time we have capitalised on opportunities that have become available during those periods.’ In the past five years the trust’s net asset value (NAV) has grown 49.4%, beating the 40.9% average of 15 UK commercial property companies tracked by Numis Securities. However, shareholder returns have been far less, in part because the stock de-rated after the company undertook a series of dilutive share issues below NAV up to 2015, with Brexit uncertainty more recently discouraging investors further. As a result, the five-year shareholder return, including dividends, has been 32%, below the peer group average of 44.9%. This reflects the wide discount of 21% below NAV at which the shares trade. Greenwood, who holds 4.5% of his trust in RLE, believes this is unjustified. ‘The West Midlands economy which is largely high-end manufacturing has enjoyed a shot in the arm as the result of sterling’s devaluation. The weaker pound has made locally produced goods more competitive on the world stage.’ However, this isn’t recognised by investors who are preoccupied with the threat to the City office market from Brexit and mark down property investment companies accordingly. If the situation persists, Greenwood says Bassi and his team might try to take RLE private which should result in an offer to shareholders closer to NAV.
This real estate investment trust focused on commercial properties in central Birmingham and the Midlands is a good example of an overlooked closed-end fund that deserves to be better known, says Nick Greenwood, manager of the Miton Global Opportunities Trust (MIGO). Greenwood specialises in buying obscure and out-of-favour stock market listed funds and waiting for their value to be realised. Although he likens trusts like this to ‘watching paint dry’, he says investors are paid to be patient with a fully-covered dividend of 3.5p per share that yields nearly 7% from a region vying to be the fastest growing economy outside London.
Real Estate Investors (RLE)
‘Many see the present environment as challenging and troublesome. We do not.’ Paul Bassi
Size: £490m Annual ongoing charge: 1.4% Yield: 6.3% (quarterly dividends) Discount to net asset value: 26%
What really spooked investors was a report from the watchdog in April questioning the leasing model for the provision of specialised supported housing to tenants with disabilities, learning difficulties and mental health problems. The RSH expressed concern that housing associations were entering into financial commitments of up to 25-years when the visibility on their earnings, underpinned by government-backed social security payments, was much shorter. Scared that the cash flows underpinning Civitas’ dividends were not secure, investors dumped the shares, which have lost a quarter of their value this year to stand at 79.5p, well below their 100p launch price two-and-a-half years ago. Having traded at a 10% premium over net asset value (NAV) last September, the shares now languish on a 26% discount below NAV. According to Civitas, the investor flight may be overdone. It says Jonathan Walter, a deputy director at RSH, told a social housing finance conference in May that the sector was experiencing ‘growing pains’ and that ‘there is nothing inherently wrong with the [lease-based] model’. Civitas group director Andrew Dawber said these more pragmatic comments from the regulator reflected the political consensus behind paying for sheltered houses for the vulnerable. ‘The regulator works for the government and the government wants them,’ he said. Meanwhile, he said Civitas was working with its bigger housing associations to improve their documentation and risk planning, which the watchdog wanted to see. Analysts at Numis Securities remain cautious but Hawksmoor Investment Management said it was holding on to shares it added to its Vanbrugh and Distribution funds last summer, although it wasn’t buying more at their current level. Fund manager Ben Conway said: ‘We have hung on to our position and think over the course of time, as Civitas is given the chance to show their model of social housing works and can prove the regulator that it can interact with housing associations that are improving, there is a path back to NAV,’ he said. ‘I think at the moment when sentiment is quite negative, we don’t need to be heroic and call the bottom on this,’ he added. Hawksmoor’s reluctance to add to its position at this level may make other investors cautious. However, annual results in June showed Civitas making progress. A total return including dividends lifted NAV per share to just over 107p in the year to 31 March. Dividends of 5p per share were only 72% covered by earnings but the company is confident it can fully cover a 5.3p pay-out this year – up 4.4% on 2018 – once it has arranged its final £160 million of borrowing and is fully invested. This would put it on a prospective yield of 6.7% on its current share price. The investment company is currently 22% geared but is aiming to reach 35%.
We stick with property because a savage de-rating in the shares of this specialist real estate investment trust could provide an opportunity for capital growth as well as a high yield if the City’s concerns about its prospects abate. But it is a high-risk punt. Civitas Social Housing launched at the end of 2016 and initially received a warm welcome from investors who liked the idea of receiving steady dividends in return for providing capital to support sheltered housing for vulnerable people. However, having raised a total of £650 million in its first year, Civitas has suffered a series of blows as a string of housing associations to which it leases its specially refurbished properties have been hit with negative rulings about their governance and financial failings from the Regulator of Social Housing.
Civitas Social Housing (CSH)
‘We have hung on to our position and think over the course of time, as Civitas is given the chance to show their model of social housing works and can prove the regulator that it can interact with housing associations that are improving, there is a path back to NAV.’ Ben Conway, Hawksmoor Investment Management.
Size: £230m Annual ongoing charge: 1.9% Yield: 11% (quarterly dividends) Discount to net asset value: 22%
The exit of Woodford removes an overhang on both stocks, encouraging buyers and improving liquidity in the shares. P2P itself is interesting on an 11% discount as it recovers under the stewardship of Pollen Street Capital, manager of the premium-rated Honeycomb. However, in April it delayed its target of generating enough income to cover its quarterly 15p dividend underpinning its 4.5% yield. By contrast, VPC, managed by Chicago-based Victory Park Capital, has covered its 2p per share quarterly dividend for over a year having - like P2P - moved away from picking ’market place’ loans from platforms, although it now lends and invests in the lending platforms themselves. This is not without risk as the administrations last year of two of the smaller platforms in its portfolio - Oakham and Borro - show. In addition, most of the platforms it backs are in the US and lend to borrowers with poor or non-standard credit histories. Nevertheless, a covered 11% yield is regarded by some as a sufficient reward. In June Schroders bought a 5.2% stake and in April LIM Advisors, which specialises in buying out-of-favour trusts, purchased 3.4% and Polar Capital added 1.9% to its financials funds. Nick Paris, director at the LIM, said: ‘VPC is still cheap, we’re looking for more price appreciation.’ ‘We’re value investors and we’re always looking for good funds where the market price is wrong. We like to see proactive change by management and boards, and VPC is actually one of our favourite funds. We’ve been receiving dividends of well over 10% per annum,’ Paris said. Nick Brind, manager of Polar Capital Global Financials (PCFT), said VPC and P2P represented a small part of the portfolio but were attractive at their current discount. ‘There’s been an improvement in performance, but they need that to continue.’
Peer-to-peer lending funds have had a similar experience to social housing investment trusts. After a bright start, the optimism soon wore off with problems at Ranger Direct, now winding down as RDL Realisation (RDL), P2P Global Investments (P2P) and VPC Specialty (VSL) leaving just Honeycomb (HONY) as the only one in the sub-sector whose shares still trade above their net asset value. VPC, launched in 2015, is worth a second look, however, as a turnaround is in progress and has coincided with distressed fund manager Neil Woodford selling a 16% stake worth £49 million in May. He also sold a holding in P2P as he desperately sought to raise cash before his underperforming Woodford Equity Income fund was overwhelmed by sales orders and was suspended in June.
VPC Specialty Lending Investments (VSL)
‘We’re value investors and we’re always looking for good funds where the market price is wrong. We like to see proactive change by management and boards, and VPC is actually one of our favourite funds.’ Nick Paris, LIM Advisors.
Size: £1.4bn Annual ongoing charge: 1.2% (2% including performance fee) Yield: 6.6% (quarterly dividends) Premium to net asset value: 4%
Shortly after the fund raise, Biopharma got a surprise windfall when GlaxoSmithKline bought one of its borrowers, Tesaro, triggering a $370 million early loan repayment. As a result Biopharma is awash with cash, $724 million at the end of April. The good news is that it has enough cash to cover this year’s dividend. The worry is whether it can re-invest the money quickly enough in new loans to ensure next year’s dividend? The company says it is looking at several lending opportunities and is confident it will be fully invested by the end of the year. If not, analysts at Peel Hunt believe Biopharma could come under pressure to return some of its capital to shareholders. In May it got the ball rolling with an $80 million loan and $25 million equity investment in BioDelivery Sciences, a small US drugs company whose main product is an opioid for patients with severe, chronic pain. Priyan Rayatt at Peel Hunt said: ‘Despite the current cash balance, we believe BPCR can provide investors with an attractive dollar-based yield, secured against high quality, uncorrelated healthcare cash flows. We also believe the built-in downside protection and transparent structuring offers greater comfort to investors than other alternative income peers offering similar yield.’
If you haven’t got the stomach for heavily discounted, debt or property funds, how about this specialist bond trust trading on a small premium? Biopharma Credit just qualifies as a ‘bargain’ as it currently stands 4% above NAV. This is actually in line with its average premium of the last 12 months but is down from an expensive 10% in March. Launched in 2017, Biopharma Credit is unique. It is the only fund listed on the London Stock Exchange that specialises in lending to smaller healthcare and biotech companies in the US. This unique selling point of earnings linked to long-term drug sales and royalties coupled with annual dividends of US$7 cents per share has drawn in investors. The company is worth £1.4 billion after a $305 million (£235 million) share issue last November.
Biopharma Credit (BPCR)
‘Despite the current cash balance, we believe BPCR can provide investors with an attractive dollar-based yield, secured against high quality, uncorrelated healthcare cash flows.’ Priyan Rayatt, Peel Hunt
Global investment trusts exposure to the pound
The direction of the pound after Brexit will be an important factor in investor returns. If sterling falls after 29 March like it did after the 2016 European Union referendum it will benefit investment trusts with lots of overseas holdings held in foreign currencies that will rise in value. Conversely, if the pound continues to strengthen as it has done this year, UK-focused trusts will do comparatively better. This table shows the amount of sterling-based assets held by global trusts over £150 million. As you can see there is a wide range between those that invest exclusively outside the UK and those that have the flexibility to invest overseas but in practice largely invest in the UK. The table also shows how far the trusts are trading at a discount below (cheap) or premium above (expensive) their net asset value. Their five-year performance is also shown in terms of underlying growth in net asset value - what the fund manager achieves - and the total shareholder returns that investors actually receive.
