10 cheap trusts to capture rebound plays in the UK and Asia

During the last week the market witnessed a spectacular switch in fortunes between growth stocks, which have massively outperformed over the last decade, and value stocks. This has left many investors wondering whether value’s short but sharp ascent will continue or whether growth will surge back. On the whole, this month’s Alpha investment trust report seems to be betting on value continuing to prosper with a significant focus on UK trusts.

The UK focus doubles-down on the bet laid by last month’s report. October’s value-focused UK picks - such as Aurora (ARR) and BMO Commercial Property (BCPT) - have already produced some spectacular returns. The possibility of a market-pleasing Brexit outcome and further vaccine developments provide grounds to hope there could be more to come, although it is by no means a given.

The story so far

Overall, last month’s ten trusts have outperformed both the FTSE All Share and MSCI World index. So too have the ten trust portfolios highlighted by the other two reports published since July. Details can be found in the accompanying table.

source: Thomson Datastream

Given the strength of the outperformance from the first three reports, and the fact that nearly 90 per cent of the 30 trusts highlighted have outdone the return from the MSCI World index, it is worth pointing out that the trust-selection strategy should not be regarded as some kind of silver bullet. While it is great to be off to a good start, experience suggests luck has played a healthy role. The strategy is very capable of delivering duff share picks as well as producing very duff ten-trust portfolios. 

That said, the strategy’s long-term record, stretching back to mid-2004, points to it generating worthwhile ideas with some regularity. Over that period the cumulative total return stands at 717 percent compared with 399 per cent from the MSCI World Index and 188 per cent from the FTSE All Share. If I factor in a notional 1.5 per cent annual charge to represent dealing costs, the total return drops to 632 per cent. Although, these reports are intended to provide ideas for further research rather than off-the-shelf portfolios.

Before delving further into this month's trust picks, let’s have a quick recap on how the stock picking process works. 

Trusts are screened based on two of the best-established factors for providing clues to future performance. The factors are:

1. 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 own one-year valuation range. This is done using a standardised measure called a 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). 

1. Momentum: Three-month share price performance 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 theme. 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.

Top 25 trusts

10 trust portfolio

source: Winterflood Securities

This month’s themes

Half this month’s trusts have a UK focus while the other picks have a leaning towards international income.

Three of the UK-equity trusts have very distinct investment approaches - Aurora, Artemis Alpha and Strategic Equity Capital. Portfolio changes at Artemis Alpha over recent years and a management change at Strategic Equity Capital give these trusts something of a special situations angle, as does noteworthy activist interest. 

The UK market as a whole, and especially value plays, have been big beneficiaries of last week’s positive Covid-19 vaccine news from Pfizer. Many of the market’s cheapest stocks are of companies that have been ravaged by lockdown and have seen shares slip to disaster valuations. Any signs of light at the end of the tunnel and a return to normality has significant positive implications.

There could be more positive vaccine news in the weeks and months ahead given many other vaccine candidates have much in common with the Pfizer vaccine. That said, there are a lot of hurdles to overcome before a mass vaccine roll-out.

The lack of visible progress with a Brexit trade deal has also been a major source of angst in UK markets. At the time of the last Alpha report the EU and Britain were meant to be imminently entering a so-called negotiating “tunnel”. However, a month on and the two sides have still not been able to find enough common ground to do this. All the same, talks are ongoing. It remains the case that intelligent compromise appears to be in both sides' best interest, so a market-pleasing result could still be delivered from the talks. A good result here is likely to once again be most beneficial to beaten-down value stocks. 

Significantly, UK equities continue to look relatively cheap despite their strong run over recent weeks.

One of the reasons many investors have lost heart with UK stocks this year is that lots of London’s big income plays have cut their dividend payouts. One way to hunt for brighter dividend prospects is to look overseas. A number of income focused international funds have cropped up in this report, particularly those in Asia. The recent victory of Joe Biden in the US presidential election has been seen as a potential positive for Asian equity markets and the announcement of the Regional Comprehensive Economic Partnership (RCEP) is another massive step forward for the region.

With the key themes established, let’s take a closer look at the actual trusts. 

Rather than follow the ranking order of the trusts with my write ups, I’ll first look at the five UK focused trusts, before coming to the rest. Given Aurora, CC Japan Income and Growth and Fidelity Asian Values all featured in last month’s report, I’ve kept these write ups relatively brief. Readers that want more detail are encouraged to look at October’s coverage.

Click here to read October’s Alpha Investment Trust report

The UK plays

The main difference between Aurora (ARR) now and at the time of October’s Alpha report is that its shares have surged nearly 20 per cent. That aside: the discount is still relatively wide; the portfolio remains concentrated and value focused; and the trust’s respected manager, Gary Channon, continues to have his interests closely aligned with shareholders. 

Given the trust has stated over recent months that there was over 140 per cent upside to the intrinsic value of its investments, even after the strong run, there could be some way further to go.

Like Aurora, Artemis Alpha (ATS) is managed by a veteran fund manager, John Dodd, and the trust also shares many of Aurora’s top ten holdings. Mr Dodd also has good alignment with shareholder interests based on his 7 per cent stake in the trust.

While the portfolio is also fairly concentrated at 39 holdings, it does offer more noteworthy diversification than Aurora. This includes a smattering of overseas holdings. As well as cyclical value plays, Artemis Alpha has focused on a number of growth themes. Online food delivery, for example, was the biggest theme in the portfolio at the time of its last results followed by video games and hobbies. So alongside potentially dirt-cheap cyclicals like easyjet and Lloyds Bank, the trust holds racier digital plays such as Delivery Hero, Nintendo and Napster-owner Prosus.

The current portfolio is the result of a multi-year overhaul of holdings. This has made the portfolio much more liquid with over two-fifths focused on large and mid cap companies. Over the last 12 months, there have been signs that the changes are really paying off with the trust boasting the best performance of all 36 trusts categorised by Winterflood Securities as investing in UK all companies, mid caps or equity income. 

Contributing to this run is the manager’s cool handing of the March crash. While the trust did take a nasty hit from the fall out, it has so far profited from its bet that the market was overreacting. A view based on over 100 vaccines being under development and huge levels of fiscal and monetary support. The trust took on debt as markets plunged to pile into cyclicals such as budget airlines and banks. Recently these bets have been paying off. However, with considerable exposure to online plays, the trust has also benefited from an acceleration of digital trends.

Investors do not yet seem to be warming to these smart moves, though. While the trust boasts the best 12-month performance of the 36-strong peer group, its shares’ discount to NAV is the second widest. Historical disappointments, including some bad bets in the resources sector, help explain reticence. However, there are also reasons to think the discount will narrow beyond the revamped portfolio’s recent success.

At the group’s next annual general meeting, which should be about 11 months away, shareholders will vote on a 25 per cent tender offer at near NAV. As this event approaches, the discount should narrow in anticipation. What’s more, the trust’s largest shareholder with a 12 per cent stake is activist investor 1607 Capital. So there is external pressure to narrow the discount and the trust has been buying back shares.

Strong recent performance, a wide discount and the presence of an activist means Artemis Alpha ticks many boxes and looks an interesting pick.  

While Artemis Alpha represents a cheap turnaround story in the mid and large cap space, Strategic Equity Capital (SEC) offers a similar narrative in small caps. But this trust's portfolio overhaul is only just beginning.

The trust’s management has recently been moved to small cap and unquoted specialist Gresham House with Aberdeen Standard also drafted in to provide marketing clout. The trust will keep its distinctive focus of applying a private equity approach to listed company investments. However, hopefully it will apply this approach with better results than has been the case over recent years when performance has disappointed. 

The strategy is based on a high-conviction, high-concentration portfolio, with the aim of taking 5 to 25 per cent stakes in companies in order to exert influence as shareholders. This sits well with the expertise of Gresham House and also the Strategic Equity’s new manager Ken Wotton. 

Mr Wotton boasts an impressive track record. He holds the highest fund manager rating from Citywire - a coveted AAA - and his LF Gresham House UK Micro Cap fund is second best performing of 42 UK smaller companies trusts over ten years. Morningstar puts 10 year annualised returns from the fund at 15.8 per cent versus 6.7 per cent.

While more recent returns have been a bit less impressive, the new manager still looks a cause for some excitement which is yet to be reflected by much tightening of the discount. Partly this could be down to expectations that the overhaul of the illiquid portfolio will take between 6 to 12 months. 

There are reasons to think demand for the shares could pick up before the portfolio changes are finished. Not only should the trust benefit from Aberdeen Standard’s marketing efforts, but Gresham House has committed to make significant purchases of the shares. This makes sense given it will be buying into one of its own strategies at a discount. 

What’s more, once again there are activists waiting in the wings to keep the trust focused on improving the valuation. 1607 is again the biggest holder with a near 18 per cent stake while another activist, City of London, has a 5.4 per cent stake. Both have been building their holdings this year.

Strategic Equity Capital ticks many of the same boxes as Artemis Alpha and again looks an intriguing pick that has the potential to create significant value if things go well. The concentrated and illiquid nature of the portfolio does carry noteworthy risk, though.

Invesco Perpetual UK Smaller Companies (IPU) is a decent small cap trust, but it hardly stands out in performance terms. What is most interesting about it at the moment is that it has a very wide discount and it appears to have de-rated for what could be regarded as a rather silly reason.

While many comparable mainstream, smaller companies trusts are trading at tighter discounts than their one year averages, the Invesco Perpetual trust is significantly cheaper than both its average and the peer group (see table). 

The discount blew out in April when the company announced it would cut the dividend because it was: “no longer appropriate since it might require a material distribution out of capital which would not be consistent with the Board’s approach to paying out a small amount only from capital.”

The reaction seems a bit odd. After all, preserving capital when there are reasons to think valuations are low surely makes sense?

True, the discount to NAV represents a disincentive for shareholders to sell up in order to create their own income stream from capital to replace income lost from the dividend cut. But arguably a more pressing concern is that dipping into capital during tough times reduces a fund’s ability to recover lost ground. 

Having decided to cut the dividend, Invesco Perpetual UK Smaller Companies took advantage of market falls to increase holdings in bashed-up cyclical plays like Gym Group and Mitchell & Butlers. These stocks have recently seen their share prices surge.

However, as bizarre as the logic of a trust selling low to pay dividends seems, the reality is that it is popular with trust buyers. It would appear the shares have been punished accordingly. Arguably, with a yield currently at over 4 per cent, Invesco Perpetual UK Smaller Companies may still actually be paying out too much.

It looks like the de-rating of this trust’s shares could be based on warped logic. That being the case, there are good grounds to hope the discount can narrow from here.

This report may be alighting on Standard Life Investments Property Income’s (SLI) shares after the horse has bolted. True, the shares are trading at a wide discount compared with the one year average and recent performance has been good. However, the good performance has been a reflection of significant discount narrowing since the trust unveiled a share buyback policy and the trust does not look like a bargain compared with the peer group.

The trust itself has a reasonably diversified portfolio and it appears to be in a decent financial position with loan to value of 29 per cent. Its calculated portfolio values would need to drop by 43 per cent and rents by 69 per cent for it to break any lending covenants. Meanwhile, although rent collection is challenging, the manager still expects to collect 90 per cent or more of amounts due. The trust has cut its dividend by two fifths in response to the crisis.

Given the discount to NAV, the recently announced policy of buying back shares makes some sense. It is a tactic being pursued by a few property investment trusts. However, given the huge uncertainty about future property values it is not a policy without risk.

Not only does the sector face the prospect of a potential major recession, but commercial property faces digital disruption from retail going online, to mass adoption of working from home. Against this backdrop the property industry is struggling to know what value should be put on bricks and mortar assets. 

The screen used by this report may be catching onto a fillip in the share price caused by the buyback news rather than the kind of deep discount opportunity it alighted on with BMO Commercial Property last month. Still, positive vaccine and Brexit developments could benefit the shares.

Heading east for income

Invesco Asia (IAT) has recently announced two new policies to help address the trust’s discount which the board aims to keep below 10 per cent. 

Firstly, shareholders will have the opportunity to vote on a 25 per cent tender of shares at the end of April 2025 if the trust has not been able to outperform the MSCI Asia ex Japan index by an annualised 0.5 per cent. 

Secondly, the trust is trying to exploit investors’ lust for dividends by promising to pay out 2 per cent of NAV every six months - based on a mixture of dividends received and the sale of underlying portfolio holdings. Despite the potentially negative impact on total returns of such policies, trust buyers tend to lap it up. 

The shareholder register provides plenty of reasons for the board to be very motivated about narrowing the discount. No less than 45 per cent of the shares are in activist hands. City of London has a 23.1 per cent stake, Lazard is holding a further 13.3 per cent and Wells Capital Management has 8.3 per cent. That’s quite some pressure that the board is likely to be feeling.

The trust itself is focused on buying shares in companies that it believes are being priced below intrinsic value. While this sounds like a mandate to buy low-growth stocks, the trust is actually focused on many big Chinese internet names such as Alibaba and Tencent. This has helped it perform strongly over the last year. Longer-term performance is less inspiring, but still not bad, and the wider-than-usual discount looks reasonably attractive.

While Brunner (BUT) does not exactly stand out among its global generalist peers, the trust has done a decent job over the years. It is also a trust that can tout a long dividend growth record. While it has continued to increase the payout this year, how sensible this will prove to be in the long-term will depend on the extent to which companies that have cut payouts during the crisis reinstate them. However, the trust’s yield does not look too demanding at less than 3 per cent.

The trust’s manager, Allianz, has recently reorganised its global investment team and Brunner has a new lead manager in Matthew Tillett. However, Mr Tillett is considered to offer continuity with the management approach of the woman he’s replaced, Lucy MacDonald. 

The trust has been moving its portfolio away from the UK for several years with less than a fifth of holdings now heralding from the London market compared with about half in back in 2004. The company has also refinanced expensive fixed borrowings, which should help improve returns. The interest on this locked-in debt has fallen from 9 per cent to 3 per cent. The trust also has a large family holding with 29 per cent of the shares in the hands of the eponymous Brunners.

In all, the discount looks reasonably attractive. All the same, as a fund it doesn’t seem to massively stand out except for the dividend record. However, given any fund can increase dividends by dipping into capital, there may be cause for a wider reassessment at some point. 

I struggled to get that excited about CC Japan Income and Growth (CCJI) when it cropped up in last month’s report. The trust has been encouraged in October by some clarification on dividends by companies and signs that buybacks are cranking up again as the Japanese economy recovers. That aside, the story seems to have changed relatively little. 

Fidelity Asian Values (FAS) is a trust that is suffering from being in the wrong markets - India not China - with the wrong approach - value not growth. The recent vaccine news could play to its advantage as could the Biden victory. A noteworthy change in sentiment is still needed.

For readers of my recent “Around the world in 8 investment trusts” feature in the main magazine this week, what follows may feel rather familiar as this trust was the top emerging market pick in that global trawl. For those less familiar, the case is as follows:

Frontier markets are cheap. Indeed, at the end of September the BlackRock Frontiers investment trust (BRFI) put the trailing price/earnings (PE) ratio of the markets it invests in at just 9; close to the lowest point in 10 years. The issue investors may have with this observation is that it has been possible to describe these markets as cheap for quite a while and they have just carried on getting 'cheaper'. 

BlackRock Frontiers defines its investment universe as all emerging markets outside of the largest eight. The trust is able to go short on stocks using CFDs, but the portfolio is predominantly 'long'. 

Covid-19 represented a really big hit for frontier markets, which generally represent the least stable emerging market economies. Not only do frontier economies tend to look fragile in terms of gross domestic product (GDP), they also tend to suffer big currency falls at times of economic stress. This makes major negative global events, such as the great financial crisis and now Covid-19, particularly painful.

Generally, BlackRock Frontiers’ aim is to capture the upside of such cycles as economies emerge from a slump, currencies appreciate and growth expectations improve. In normal times, these economies tend to have different cycles. However, things change when a single major event takes down all comers. The opposite has the potential to hold true, though, as the world recovers from the pandemic. With a view to playing a recovery, the trust has been leaning towards cyclicals over growth stocks. The positive spin that has been put on the US presidential election results for emerging markets may well help sentiment.

The trust also sees its portfolio as offering diversification from the risks associated with investors’ current fixation with big tech stocks in China and the US. The trust also put a focus on dividend-paying stocks, which supports the trust’s own income credentials, although Covid-19 has seen some cuts to payouts by companies in the portfolio. Recent vaccine developments should help.

There is activist interest here, too, with City of London having emerged on the register this year and building its stake to 11 per cent of the shares. 

That's if for this report and for a year as we will be taking a break in December with the next Alpha investment trust report scheduled for January 2021.

Happy holidays!