Seeking value

This growth bias has helped produce a good performance relative both to its benchmark and the Income portfolio. But one should always remember that the concept of 'value' has wider implications when considering an investment trust portfolio - particularly when the objective is growth!

The equity strategy debate

Although value stocks have had their moments in the sun, since the first signs of the subprime troubles emerged in 2007, growth stocks have outperformed. Indeed, this is an unusually long period of outperformance - some suggest the longest since the 1920s.

This is plausible. The extent of the West's borrowing binge has truly revealed itself. The previous government took on more debt than all previous governments combined in the 300-year history of the National Debt. The debt more than doubled. For every four pounds spent, one was being borrowed.

Britain was not alone. The eurozone crisis showed what can happen when markets lose confidence in a country's ability to repay. There comes a point when the credit card can no longer be used with sweet abandon.

The extent of this debt is important when discussing markets. Despite financial repression and quantitative easing (QE), the debt remains enormous. You cannot borrow your way out of debt. Yet, despite all the talk of austerity, this government has only reduced the deficit by one-third - we are still adding to the National Debt at two-thirds the rate.

Burdened by so much debt, economic growth rates are going to remain sluggish relative to past experience. High debt piles are an enormous weight for economies to carry. Assuming countries do not default, it will take many years if not decades for such debt to be reduced to more sustainable levels.

It is no surprise therefore that growth stocks have outperformed. If growth is hard to find, investors will pay up for it - despite the low interest environment highlighting the attractive yields on offer from value stocks. And this will be particularly the case as the QE taps slowly get turned off, interest rates rise and concerns swirl as to how sustainable the economic growth will be.

This will not stop value stocks having their moments. March has seen a major rotation in their favour - the second biggest since the bedlam of 2009. This may continue for a while.

But unless growth valuations exceed reason - even technology and biotech stocks are nowhere near as expensive compared to previous peaks - and until debt piles are no longer a drag on growth, then I suggest growth will resume its outperformance.

The Growth portfolio will therefore maintain its equity 'growth' bias. The Income portfolio will continue to adopt a similar approach as far as it can within the confines of its brief.

But the wider concept of 'value' is still relevant to investment trust portfolios when making an investment decision. An investor has to consider two further factors: the 'value' of both the trust and that of the underlying market, sector or theme. The two then have to be fused when making that decision. Indeed, the challenge is greater for the Growth portfolio because it has more freedom - there is no income restriction.

Growth portfolio changes

With this in mind, I have re-examined the extent of the Growth portfolio's overweight exposure to technology. The preference for growth stocks, the investment spend cycle and a host of positive secular trends, including cloud computing and e-commerce, all bode well.

But since again advocating the case (Technology: Unloved and undervalued, 9 August 2013), and introducing RCM Technology Trust (RTT) when standing on an 11 per cent discount, the sector has had a good run. Despite my continued enthusiasm, I have to acknowledge company ratings are not what they were and, in addition, RTT's discount has all but gone. I have therefore sold RTT and taken a 30 per cent profit after expenses. The Growth portfolio remains overweight technology, courtesy of Herald Investment Trust (HRI), which presently stands on a 16 per cent discount.

Meanwhile, I have introduced a new holding of Strategic Equity Capital (SEC). The managers invest in companies which will benefit from strategic, operational or management change. The emphasis is very much on constructive corporate engagement in order to enhance shareholder value. It is, in other words, seeking value and believes smaller companies offer the best anomalies.

Such an approach makes for a concentrated portfolio. Speaking with the managers, I was impressed by their focus on private equity disciplines as a means of identifying and unlocking value. Interestingly, technology represents around 40 per cent of the portfolio - which compensates somewhat for the sale of RTT. A superb track record and 10 per cent discount warrants its inclusion in the portfolio.

Meanwhile, the Japanese market has had a bad first quarter. Given the investment case remains intact for reasons given early last year (Japan: A once in a lifetime opportunity, 8 February 2013), I have used the present weakness to add to our existing holding of Baillie Gifford Japan Trust (BGFD). The trust itself is not cheap, standing at NAV when bought - a little below its recent average rating of 2 per cent premium.

But I believe the underlying market still represents good value, despite its strong run last year. Indeed, an average price-to book ratio of 1.5 represents better value than most other markets. Furthermore, because of political pressure, there is a growing likelihood of shareholders benefiting from large corporate cash piles. Japanese companies trail well behind their international peers when it comes to return on equity.

A host of other factors add to the investment case. Decades of deflation has left its mark - the preference for bonds and cash runs deep. Japan's huge pension funds have only around 15 per cent in equities. Domestic households only account for around 20 per cent of the Japanese stock market - it used to be much higher.

Various government initiatives to boost equity investment via both pension funds and tax-free savings accounts could have a significant effect on the market. In addition, government efforts to raise inflation courtesy of a massive dose of QE should further encourage investors both large and small to look again at their domestic equity market - for savings rates are miniscule.

This will be a slow burning fuse. But the combination of attractive valuations and liquidity should reward the patient investor.

There were no changes to the Income portfolio during March.

View John Baron's updated Investment Trust Portfolio.