10 investment trusts for value and performance

This is the third Alpha investment trust report. This report attempts to identify attractive investment ideas based on trusts showing a virtuous combination of strong recent performance and attractive valuation. 

While it is still very early days in the life of this regular report, the trusts highlighted by the first two Alpha reports have been doing well. All 20 of the trusts have so far produced a better total return than the FTSE All Share and 17 have out done the MSCI World index. Overall, the ten trusts highlighted in July’s report have delivered a 12 per cent total return over the last three months compared with a negative 4.2 per cent from the FTSE All Share and 3.7 per cent from the MSCI World index. Meanwhile the ten trusts from September have returned 7.4 per cent in a month compared with negative 2.2 per cent from the FTSE All Share and a positive 2.1 per cent from the MSCI World index.

July and September performance

Source: Thomson Datastream

While it is nice both that the two ten-trust selections are off to a good start, a month or three is not a decent period over which to judge performance. However, more faith can be put in the near eight-fold total return since mid-2004 based on the reports' stock selection process. The 693 per cent total return compares with 268 per cent from the FTSE All Share and 490 per cent from the MSCI World. This cumulative return is based on annual reshuffles and does not include any notional dealing costs - I’d say we’d be closer to 600 per cent if a 1.5 per cent annual dealing cost were factored in and I will endeavour to do this next time this report is published..

Source: Thomson Datastream

The longer-term performance also illustrates that the process that sits behind this report, while historically effective, is far from faultless. The ideas do not always work out, although, normally there is plenty of food for thought. And while the investment trust selection process is designed to produce a reasonably diverse 10 stock portfolio, the main purpose is to highlight individual ideas that may be of interest for further research rather than providing off-the-shelf portfolios.

The strategy

The criteria used to select investment trusts is as follows:

Value: To fairly compare investment trusts with different remits and capital structures, valuation based on share-price discount to net asset value (NAV) is assessed relative to a trust’s one-year average premium/discount. This is done using a standardised measure called the Z-score (the number of “standard deviations” the premium/discount is from the mean average). A Z-score can be considered to be pretty cheap when it gets below -1 (the bottom 16 per cent of the range) and extremely cheap below -2 (the bottom 2.5 per cent). 

Performance: Three-month share price momentum is used as an indicator of sentiment towards trusts and their recent investment success.  

The tables below show the top 25 investment trusts based on a combined ranking of Z-score and momentum. The 10 stock portfolio meanwhile, which is what this report focuses on, represents the highest ranking trusts that meet the following portfolio rules: 

* Market capitalisation must be more than £100m.

* No tracker or hedge funds.

* No more than half the portfolio (five out of 10 shares) should have “niche” themes, and no more than two trusts should have the same niche. Trusts defined as niche are those focused on non-mainstream asset classes or sub-sectors such as private equity, debt, technology and biotechnology, and those focused on single countries (excluding the UK and US) or high-risk economic regions such as emerging markets. Asian smaller companies trusts are also regarded as niche, but not Asian generalists.

* No more than half the portfolio (five out of 10 shares) should be mainstream trusts of the same type. This rule does not apply to global funds, but it does to other mainstream themes such as trusts investing in the UK (large and small companies), Europe, the US or Asia.

* All trusts’ share prices must be at a discount to NAV.

Here are the top 25 trusts:

Here’s the ten trust portfolio:

Source: Winterflood Securities

So, what has this month’s screen highlighted?

Troubled times

If there is a common theme in this month's report, it is trusts focused on countries that appear to have their backs against the economic wall. Specifically, the UK and India. Three of the trusts focus on UK equities (Aurora, Independent Investment Trust, and Standard Life UK Smaller Companies). All these happen to be managed by respected veteran fund managers. Meanwhile, another pick, BMO Commercial Property, is focused on prime UK real estate. 

The Indian connection is a bit less obvious from the trust picks, as only one trust is solely focused on the country; JP Morgan Indian investment trust. However, the two Asian generalists highlighted (Fidelity Asian Values and Pacific Assets) both have high exposure to India. All three of these funds were also among the six Asia-focus trusts selected in last month's screen picks when the region represented the stand out theme. These three trusts lagged the performance of the trusts that had a heavier focus on China and technology. This in itself perhaps tells us some of the challenges investors see ahead for India.

Stimulus stymied?

The common problem faced by both the UK and India is that lockdown has led to a major drop in GDP and both economies are walking a bit of a tightrope when it comes to financing a recovery. 

In the case of the UK, the first month of lockdown knocked about a quarter off gross domestic product (GDP) and the Office of Budgetary Responsibility (OBR) has forecast a 12.4 per cent fall this financial year as its central scenario. Meanwhile, in seeking to protect the economy, the country’s borrowing requirements have blown out. Forecasters think borrowing requirements for the year - the so-called budget deficit - could hit as much as £400bn, or about a fifth of GDP. 

Some may see a get out for the UK in the brave new world of Modern Monetary Theory (MMT). Supporters of this increasingly-popular school of thought argue that as long as inflation is low, governments should employ fiscal stimulus funded with money printing. Meanwhile MMTers regard balancing the books as a red-herring as long as debt is denominated in a country’s own easy-to-print fiat currency. 

The trouble for the UK is that the relative weakness of its economic position, its somewhat diminutive size on the world stage and its reliance on exports means that were it to heavily push MMT ideas, it could mean a run on the pound. Indeed, the chancellor, Rishi Sunak, has recently made a point of signalling his intentions to balance the books, even though the last thing the enfeebled UK economy needs is a dose of austerity. That said, at this point any chancellor worth their salt would be thinking about the stage-management needed to keep international markets on side. Last week’s one-notch downgrade of UK debt by credit rating agency Moodys to Aa3 is a reminder of how important this is.

The other issue for the UK is Brexit. Talks with the EU were meant to have entered their black-out-phase last week and no deal looms as a prospect. A no deal outcome could prove very messy and costly for the UK. However, as it is also not desirable for the EU, there are grounds for hope something is pulled from the hat before the end-of-year exit date. Indeed, the key points of contention - fish and state-support - seem relatively minor compared with what is at risk for both sides. 

Positive news from negotiations could provide a major fillip to UK shares. This was the situation at the end of 2019 when markets rallied hard, although that now seems a very distant memory. 

The potential for a noteworthy change in fortunes for UK equities is increased by recent selling by investors. UK-focused equity funds have seen major outflows in recent months, which is usually regarded as a positive contrarian signal. What’s more, while key constituents of the UK index, such as the big banks and oil majors, have problems that justify low valuations, there is a credible argument to be made that the UK market looks cheap based on a cyclically adjusted price/earnings (CAPE) ratio of 12.1 times, according to Star Capital data. A CAPE values prices against 10 year average earnings to try to account for an entire economic cycle.

Looking at India, it faces many problems which are similar to those of the UK. GDP was down 24 per cent between April and June with a 9.5 per cent drop forecast for the financial year by the Reserve Bank of India. Meanwhile, a budget deficit of about 13 per cent is expected this year. The country is hemmed in further by the fact that over half of its debt is denominated in dollars. This means it does not have the money printing wriggle room of the type espoused by those MMTers. Indeed, the limited room for manoeuvre was arguably reflected in a recently announced $10bn stimulus package which some saw as too little.

However, the great hope for investors in India is the country's demographics. Its large young population is seen as a major plus in a world where most developed countries are aging fast. This untapped potential is reflected in the Indian stock market’s relatively high rating, with a CAPE of 21.1 times.

That’s the background taken care of. Time to look at the trusts starting with those from the most well represented region, the UK.

Home-grown trust picks

Standard Life UK Smaller Companies (SLS)

Source: Winterflood Securities/Factset

Unlike the other UK equity funds in this report, Standard Life UK Smaller Companies has put in a strong performance during the Covid-19 pandemic. The longer-term record is also very commendable. The trust has been managed by highly-respected small-cap veteran Harry Nimmo since September 2003 and in that time has delivered average annual returns of 15.6 per cent. 

Mr Nimmo’s focus is on finding quality growth stocks. Underpinning his selection process is a screening system called “the Matrix” which helps hone the trust’s focus. The portfolio constituted 55 holdings at the half year stage and bore little resemblance to its benchmark with a so-called active share (a measure of how different the portfolio looks to its index) of almost 90 per cent.

The recent widening of the discount looks less to do with the trust’s performance and more likely a reflection of generic concerns about the vulnerability of UK small caps should there be a bad Brexit outcome or a severe second lockdown. 

However, many of the portfolio holdings are companies that benefit from trends that have been accelerated by the pandemic, such as home working and internet shopping, as well as companies pursuing international growth. The trust’s discount should also be seen in light of the board’s aim to keep it inside 8 per cent, which means the valuation is now close to the trust’s outer comfort limits.

It’s fair to say Mr Nimmo is no spring chicken, which means there are questions about how long he’ll want to stay at the helm of the trust. He does seem committed, though, and recently increased his focus on the fund when he stepped down from his role as Aberdeen Standard’s head of smaller companies. He’s also made a commitment to keep managing the trust until 2022 and it is thought likely he will remain for longer still.  

The trust’s costs have also been coming down recently following the merger with another fund in 2018. That said, UK small companies are one of the few areas where, on average, it has historically actually been worth paying the fees associated with active management. This is especially true with investment trusts, which benefit from having captive funds. This helps avoid the performance drag that researchers have found accompanies fund flows in and out of open-ended vehicles.

Independent Investment Trust (IIT)

Source: Winterflood Securities/Factset

Independent Investment Trust has had a lousy Covid-crisis. The trust sold many of its cyclical holdings, such as house builders and equipment hire firm Ashtead, as markets bottomed and moved heavily into cash. Indeed, the cash position doubled in March from about 13 per cent to 26 per cent. 

Subsequently the trust, run by veteran septuagenarian fund manager Max Ward, has stayed on the sidelines whilst watching many of the shares it sold soar. In the past Mr Ward has been quoted as saying he does not try to make short-term calls on the market. While it is easy to understand the long-term thinking behind the sales based on the awful economic outlook, he does seem to have been caught out by a savage short-term swing during the crash. The last reported cash positions remained high, so he may yet find an opportunity to strike if new lockdown measures and Brexit cause another lurch downwards.

The trust’s shares are now a very long way from their May 2018 peak of 800p, when they traded at a 20 per cent premium to NAV. The move from a premium to a discount has been a major issue for investors with the five year share price total return quoted in the accompanying table of 38 per cent, comparing with a NAV total return over the same period of 50 per cent.

The role played by discount volatility is not the only reason it is worth looking beyond the trust’s torrid recent share price run. The trust’s portfolio is very concentrated and very tech focused, which has served investors extremely well in the past. The largest holding is actually the top performing trust pick from last month's Alpha Investment Trust report; Herald investment trust. Other big positions include gaming stocks and shares in IT consultancy companies, such as Gamma Communications and FDM.

The manager meanwhile is highly experienced having been a partner at Baillie Gifford from 1975 before launching Independent Investment Trust in 2000. Before leaving Baillie Gifford he was manager of the now flagship Scottish Mortgage investment trust. Mr Ward has said he plans to carry on running Independent for as long as he is able. The board has previously said that when he steps down it plans to offer investors the choice of a cash exit or a roll-over into another fund. 

Another noteworthy feature of Independent Investment Trust is that it has very low management fees. At about 0.25 per cent, these are on par with an ETF, although, management of the fund is very much active.

Aurora investment trust (ARR)

Source: Winterflood Securities/Factset

Aurora continues the theme established by Independent Investment Trust, insofar as it has fallen on hard times recently but is run by a veteran fund manager who has been able to deliver some stunning performance in the past. The manager in question is Gary Channon, founder of Phoenix Asset Management. While Phoenix only took over management of the trust in 2016, the strategy is the same as that used by the Phoenix UK Fund. That fund has a far longer record stretching back to 1998 and has produced annualised NAV performance of 7.2 per cent in that time, compared with 4.2 per cent from the FTSE All Share.

Mr Channon’s focus is on in-depth research that aims to identify stocks that offer at least 100 per cent upside to their estimated intrinsic value. The portfolio is also very concentrated. With both “value” investments and the UK market both unpopular over recent years, the trust performance has struggled. This has seen the shares move to a discount compared to the premium rating that has more typically been commanded since Phoenix took over management.

Covid has not been kind to the portfolio, which has big stakes in retailers and budget airlines. One stock that has seen better fortunes as a result of lockdown is undertaker Dignity, which has benefited from the competition and markets authority (CMA) announcing a temporary reprise in its plans to introduce industry price caps. The stock has gained nearly 150 per cent gain in the past three months. 

Still, lockdown has seen more go wrong than right for Aurora so far. Mr Channon now reckons the portfolio is trading at a discount to intrinsic value of over 140 per cent. Broker Liberum points out that when valuations have got this extreme for the Phoenix UK in the past, which has happened at the end of 28 previous quarters, it has been followed by strong outperformance over three years averaging 61 per cent, or 17.2 per cent annualised.

Mr Channon has significant financial, as well as reputational incentive to see performance pick up. His firm is only paid if the trust outperforms the FTSE All Share, pocketing one third of these returns. What’s more, Phoenix gets paid in the trust’s shares and is not allowed to redeem these for three years. Focusing the mind further, the fee is subject to a claw back if the outperformance is not maintained during the lock-in period. Given Phoenix only earned its first fee of £1.4m last year, when Brexit progress put a strong gust of wind in the portfolio’s sails, performance needs to be pepped up for the manager to get paid in full.

BMO Commercial Property (BCPT)

*as of 30 Jun

Source: Winterflood Securities/Factset

BMO Commercial Property is another trust that the market has judged to have made all the wrong moves around the crisis. Indeed, what broker Kepler Trust Intelligence describes as its “Armageddon-like” discount reflects the depth of concern. The main reasons for consternation is the trust’s decision to be underweight in the one area of the mainstream UK property market that appears to still have some fight in it: industrial real estate. Instead the portfolio’s big focus is on offices (about two-fifths of its holdings) and retail (one-fifth). The question is, can things really get as bad as the massive 48 per cent discount to NAV implies.

Debt is the issue that really sinks real estate companies, and on this front things do not look too desperate. The company’s loan to value stood at 23 per cent at the half year stage, or 30 per cent based on net debt as a proportion of NAV. 

Its big £260m debt facility with Legal & General is in place until 2024 and at the half year mark was not in much danger of breaching covenants. Meanwhile the trust has just pushed out the maturity of a £100m loan revolving credit facility with Barclays from June 2021 to June 2022 with options for further extensions. While the interest on the loan, if drawn, has increased from 1.5 per cent over Libor to 1.85 per cent, the charge does not suggest the bank views this as a distressed situation.

Rent collection meanwhile has weakened significantly but not as badly as many had feared with broker Investec putting second quarter collections at 84 per cent and third quarter collections at 81 per cent. 

Meanwhile average unexpired leases stand at just over 6 years. The focus on prime property should also help tenant security. Indeed, two fifths of the portfolio is located in London’s usually bustling West End. This should also help the company benefit from any broader recovery and potentially gives it a better chance of hanging on to office tenants as working from home becomes a more dominant practice. 

There is a huge amount of uncertainty about what will happen to tenant demand not only due to the collapse in the UK economy but also because of the digitalisation of both retail and office work. However, at times like this the psychology is prone to make investors price in the worst. It’s very contrarian, but the level of discount suggests there could be good upside if the next few years are anything other than terrible. 

The trust has also been confident enough to reinstate its dividend at half the previous level, which means investors are currently in line for a 4.7 per cent dividend yield paid in monthly installments.

Asia again

The three Asian trusts highlighted in this report also featured last month. Fresh developments are covered below, and the link to last month's report for further background is here.

Pacific Assets (PAC)

source: Winterflood Securities/Factset

Interim accounts were published by Pacific Assets this month. The main takeaway from this was to simply underline the themes I wrote about last month, in particular the tough period the company has experienced recently due to its high exposure to India and low exposure to China and tech. 

Another recent development was that the trust’s auditor KPMG resigned at the start of the month after identifying that its re-appointment in 2017 represented a technical breach of the requirements of the Companies Act 2006. Given a key selling point of the trust is its focus on ESG issues, neglect of governance standards in the trust’s own affairs is perhaps a bit more of a concern than it otherwise would be. 

Fidelity Asian Values (FAS)

Source: Winterflood Securities/Factset

This month Fidelity Asian Values publishes full year results heaped with consternation and contrition from both the fund’s manager and the board. The chairwoman lamented that: “Value, as an investment style, is experiencing the longest and deepest underperformance relative to growth since the 1960s. Value stocks considered across a range of valuation metrics, including price-to-book and price-to-earnings multiples, have not traded so cheaply since 1968.” 

Meanwhile the manager, Nitin Bajaj, self-flagulated over “errors of omission” (if only the trust hadn’t avoided healthcare and tech) and “errors of commission” (if only the trust had not owned Indian mortgage companies).

The fact that the chairwoman felt the need to emphasise the board's “full support” for the manager suggests both parties may be feeling the pressure after a torrid run over the past few years. The trust ‘s longer-term track record, though, suggests hope of an improvement are not without foundation, but there is likely to need to be a major change in dominant market trends for this to happen.

JP Morgan Indian (JII)

Source: Winterflood Securities/Factset

Since last month JP Morgan Indian has reported a change in management fee, which broker Investec calculates should cut about 0.23 of a percentage point from the annual charge. The trust, which had a heavily oversubscribed tender offer earlier in the year, has also recently been buying in shares. This should help keep the discount in check.

Three more for the pot

Two of the three other trusts featured in this report (JP Morgan US Smaller Companies and AVI Global) were also highlighted in July. Both have put in decent, but not exactly standout performances since then. Discounts remain relatively wide and coupled with solid three month returns this makes them of interest once again based on the report’s selection process.

JP Morgan US Smaller Companies (JUSC)

Source: Winterflood Securities/Factset

JP Morgan US Smaller Companies investment trust has a solid record for beating the Russell 2000 index under the charge of long-term manager Don San Jose. It delivered a solid performance during the crisis, too. The trust’s key focus is on holding shares in companies with durable franchises, stable earnings and strong management teams. 

While generally performance has been alright, one way the trust has lost out this year is from its low exposure to the healthcare sector and no biotech holdings. Another area it has no holdings in are direct energy companies, having recently decided that the outlook for the sector is terrible.

The outcome of the US presidential election in November could cause ruction. In particular, with the Democrat candidate Joe Biden currently polling strongly, a reversal of some of President Trump’s corporate tax cuts could be on the cards. However, the market reaction to election outcomes can be unpredictable. Indeed, some view a strong Democrat win as potentially opening the floodgates on a massive stimulus splurge. This could be a big benefit to smaller companies, which are generally perceived to be more sensitive to the domestic economy.

From an investment trust industry perspective, it is of note that the only other US smaller companies trust, Jupiter US Smaller Companies, has recently announced the retirement of its long standing manager. There is perhaps some chance this will have implications for the JP Morgan fund because this part of the market is so incredibly niche.

AVI Global (AGT)

Source: Winterflood Securities/Factset

AVI Global is a value investor of a very particular bent. The trust looks to buy into closed end vehicles and holding companies that trade at a discount to the value of their own holdings. This means the shares offer investors a discount on a discount. At the end of August the discount on underlying holdings was estimated to be 34 per cent. 

While this is very much a value investment style, many of the ultimate underlying holdings are actually tech plays. For example, recently strong performance has come from Swedish holding company VNV which AVI bought into earlier this year due to its holding in a tele-medicine business called Babylon. 

Other top holdings include the likes of Kinnevik and Softbank which offer exposure to high-profile internet and technology names. The trust is one of several investors putting activist pressure on Softbank, attempting to impose stricter corporate governance standards. There have been some signs of this being successful, although, news this month that Softbank plans to launch a SPAC, suggest the company remains relatively free-wheeling. SPACs are a kind of US shell company used for reverse takeover and have recently been popular in what many regard as a frothy market.

The trust’s biggest position at 19 per cent of assets is a “basket” of Japanese special situations. It has attempted to exert activist pressure on some of these holdings which has met with some success. Key to the enthusiasm for Japan is the government’s reformist policies. Shinzo Abe, the man behind this push known as the “three arrows”, has recently stepped down as prime minister due to ill health, but AVI is confident his successor will keep up the policies.

This is an interesting trust based on its fairly unique approach, but over the long-term performance has been poor relative to global indices. That said, over the last six months returns have been relatively good and if that can continue there may be reason to hope the discount can narrow.

CC Japan Income & Growth (CCJI)

Source: Winterflood Securities/Morningstar

Heading into the Covid-crash with structural gearing (debt used to fund share purchases relative to net asset value) of 20 per cent was definitely unfortunate for CC Japan. It’s focus on sustainable and growing dividends also did little to shield it from the sell-off with its holding in real estate investment trusts (Reits) doing particularly badly. Indeed, over a year the trust performance is by some margin the worst among its six-strong peer group. It is also the sector dog over shorter periods; so far it would seem the trust’s portfolio positioning has prevented the gearing working to much positive effect as the market has recovered from lows.

Still the trust’s manager sees reasons to remain positive. Like AVI Global, the resignation of Japan’s prime minister is not expected to be a setback to reform efforts. Indeed, Mr Abe’s successor, Yoshihide Suga, is seen as having been very instrumental in creating the reformist agenda. What’s more, the benefit of policies on corporate tax rates, employment and governance standards are regarded to be established enough to ensure momentum. 

Overall, CC Japan believes the improvement in return on equity (RoE) experienced in the Japanese market over recent years should continue, along with prospects for dividend growth and improved valuation. That said, while Japan is considered to have dealt well with the pandemic, it has inevitably led to many companies pulling payouts due to a serious deterioration in their prospects.

The trust is also encouraged by the recent purchase of listed subsidiaries by parent companies on the Japanese market. It points out that about 600 Topix companies, or 17 per cent of the index, have a controlling listed shareholder.

There are arguments in favour of the Japanese market at the moment, however, it is harder to see the compelling case for shares in CC Japan beyond its discount, which is only slightly high compared with the standards of the last year. Covid has also made the case for investing for dividends substantially weaker, especially as many so-called dividend investment trusts are now making payouts by selling underlying holdings. This only goes to highlight the advantages of viewing investments on a more flexible “total return” basis.