Regular readers will know that I'm on a mission at the moment in seeking 'value' as a means of cushioning portfolios against possible market turbulence. But, when applied to investment trusts, the concept can be applied to both the discount and underlying portfolio.
Hence the introduction of Oryx International Growth Fund (OIG) and Henderson Far East Income (HFEL) to the Growth portfolio during October – space in last month's column not allowing me to explain why in any detail.
Oryx International Growth Fund
OIG invests in small and medium-sized quoted and unquoted companies, mostly in the UK but also in the US. Its approach is a little different to other more 'mainstream' smaller company investment trusts in that it seeks companies with strong business models but which may, for a variety of reasons, have factors constraining their performance.
Taking an activist approach as a shareholder, it works with managements to crystallise the inherent value. This process is helped by its expertise in spanning the public/private equity divide. As such, OIG's portfolio is more concentrated than most as the emphasis is on taking reasonable stakes and knowing the companies very well indeed.
It's an approach that has paid off over the years. Under the stewardship of Christopher Mills, performance has been very good. When I last looked at the end of November, OIG has produced a total return of 13 per cent, 89 per cent and 130 per cent over one, three and five years, respectively. This compares well against both peers and the various indices.
And yet, it still sits on a generous discount. When I first mentioned OIG in last month's column, the discount was around 25 per cent. Since then it has narrowed and, at time of writing, is now around 16 per cent. However, this still represents good value given its track record, which is why I have topped up the holding during November.
Looking forward, there are a number of positives. I remain of the view that portfolios should be overweight smaller companies over the longer term. OIG's approach is particularly well suited when applied to this under-researched area of the market, and this should continue to serve it well – especially given an earnings environment which will remain difficult. With liquidity effectively around 13 per cent, powder is being kept dry for further opportunities.
Furthermore, its expertise and flexible mandate, both in terms of geography and in crossing the public/private divide, will remain a relative strength. The unquoted element comprises less than 10 per cent of the portfolio at present, but historically OIG has a good record at crystallising value from such investments.
There remains one vital component which I always look for when seeking unfashionable trusts – managements with sizeable stakes. Christopher owns around 30 per cent of north Atlantic Smaller Companies Investment Trust (NAS) which in turn owns 42 per cent of OIG. A further 1 per cent of OIG is owned directly.
Such a healthy stake strongly aligns the manager's interests with that of shareholders – it is in everyone's interest that the discount narrows over time.
Henderson Far East Income
But seeking 'value' is not always just about finding investment trusts on unduly wide discounts. It can and does involve ‘seeing through’ to the underlying portfolio and making a judgment as to its worth relative to the wider market. And this is where Henderson Far East Income comes in.
Run by Mike Kerley, HFEL trades on a small premium to NAV and as such one would not normally think of it as undervalued. But the underlying portfolio is invested in a number of unfashionable sectors. This is partly because the manager is very conscious about the need to avoid overpriced yield.
Around half of the portfolio aims to capture high but sustainable yield on attractive valuations – although this is becoming harder to find. Examples include Chinese banks which are on a price/earnings ratio (PER) of around five to six times and yield over 7 per cent. Such valuations would suggest a lot of bad news is in the price.
The other half focuses on achieving good dividend growth, even if this means the initial yield starts from a lower base. This element of the portfolio is short of defensive sectors such as telecommunications, consumer stables, utilities and healthcare which look expensive after their strong run. Instead, the focus is on less fashionable sectors such as industrials, consumer discretionary and technology.
The overall effect of this dual approach is that the portfolio stands at a significant discount to the wider market. The portfolio’s PER is around 11.6x compared to 13.5x for the index excluding Japan. This affords some comfort in a world where certain market valuations are looking stretched. Indeed, some of the portfolio's out-of-favour sectors are beginning to look very cheap indeed.
Meanwhile, I suggest HFEL's impressive dividend record is being undervalued. Since 2007, it has grown the dividend on average by 7.2 per cent per year, compared with 3.3 per cent for the region and 2.1 per cent for the FTSE 100. The present yield of 5.7 per cent is supported by both a steely determination to build on this record and a healthy revenue reserve of around 60 per cent of one year's payout.
Meanwhile, the outlook for dividend growth across the region is also positive. Payout ratios are low – in fact, standing around 30 per cent, they are at historically low levels. There is plenty of scope for this to improve, and we could see dividend growth exceed earnings growth over the next few years.
A good dividend record is helpful to ambitious companies' credibility when seeking capital from the markets, and to an elder generation of the many family-controlled businesses as they now approach retirement.
In short, HFEL looks attractive. An experienced fund manager invested in attractively rated sectors, a high and sustainable yield which is growing at a healthy rate, the positive outlook for the region in general, and a good exposure to China which I suggest is one of the most undervalued markets at present, all suggest optimism.
Portfolio changes
Otherwise, during November, I have sold the Growth portfolio's holding of BlackRock Frontiers Investment Trust (BRFI) when on a small premium to NAV, and used the money to add to the portfolio's existing holding in Fidelity China Special Situations (FCSS) when on a 12 per cent discount.
I shall explain why in more detail in next month's column. But suffice to say here that, relative to each other, FCSS looks the more attractive whether comparing discounts or the underlying portfolios.
The Income portfolio retains BRFI because it does have a yield, and because of the portfolio's existing and larger holding of HFEL with its meaningful exposure to China. As such, there were no changes to the Income portfolio during November.
