Investment trusts to ride out choppy waters

Having been more defensively positioned than normal in recent years, which has compensated somewhat for discounts widening over the period, the John Baron Investment Trust portfolios have been gradually increasing their equity exposure at the expense of more defensive assets such as capital preservation trusts, commodities, renewable energy and cash.

Market volatility is set to continue for a variety of reasons, and such a journey and pivot, no matter how measured, is rarely a smooth one. Our compass in these choppy waters remains firmly fixed on UK equities and private equity companies given their attractive valuations and prospects. However, this month also saw a global generalist company added to the portfolios – one that very much focuses on investments that are attractively valued, including Japan.

Making progress

Last month’s column set out in some detail the challenges facing the market. More volatile and ‘stickier’ inflation than central banks are forecasting, higher interest and discount rates, and elevated ‘growth’ valuations after a long period of outperformance, have helped to create a challenging market environment. Other geopolitical and economic factors including the hardening of strategic alliances and continuing high debt levels have contributed. In addition, such factors have also helped to usher in a new market regime that will favour ‘value’ over ‘growth’ as an investment style for the reasons set out in the column ‘The ending of an era’ (23 September 2022). The market has much to countenance.

In increasing the portfolios’ equity exposure in recent months these challenges are not underestimated. The fact global policymakers have been behind the curve when it comes to controlling inflation and their continuing poor record of forecasting is one such challenge. This will remain a source of volatility for markets. It is crucial for central banks to get a grip in both senses because such errors are adversely affecting the real economy and peoples’ lives as households struggle through a cost of living crisis. Inflation and the level of interest rates affect everything from mortgage rates to business loans, from wage negotiations to spending plans. Yet the omens are not good.

Recent testimony by the Bank of England (BoE) to the Treasury select committee highlights the extent to which inflation modelling needs updating. While no one can predict Black Swan events, claims that unexpected shocks such as the invasion of Ukraine accounted in large part for the leap in inflation that took central banks by surprise simply ignores reality. In the period leading up to the invasion, inflation rose steeply. Money supply figures were high and clear signs of inflation were evident in the economy. A month before the invasion, inflation stood at 6.1 per cent, and yet interest rates remained at 0.5 per cent – woefully inadequate if the BoE was serious about its remit of keeping inflation under control, and preferably below 2 per cent.

There is strong evidence to suggest quantitative easing (QE) went on for too long, and this helped to stoke inflation. The first round restored bank balance sheets, but the second reached the real economy. The BoE denies this. But, as professor Tim Congdon and James Ferguson highlight, how does the monetary policy committee (MPC) explain that China, Japan, Switzerland and others who faced the same supply shocks but, because they had not inflated the money supply, saw virtually no inflation? Quantitative tightening (QT) will prove just as problematic. At least the BoE last month finally increased its short-term inflation forecast from 3.9 per cent to 5.1 per cent – a big increase. The Office for Budget Responsibility (OBR) is sticking to its forecast of 2.9 per cent for now, but reality was also dawning.

Other geopolitical concerns

Market volatility is also reflecting other geopolitical and economic concerns. The nuances that used to facilitate diplomacy are fading and strategic alliances more generally are hardening following the invasion of Ukraine. One manifestation is that key countries and trading blocs are focusing on the importance of key supply chains being ‘onshored’ or at least relocated. This is more likely to be inflationary than not, but also has wider connotations. Key commodities and artificial intelligence (AI) are proving to be further pieces on the chessboard. The Atlantic Declaration, a US-UK economic partnership, gives testimony to the importance major nations are attributing to such developments.

Meanwhile, the high levels of debt within the global ecosystem, despite the extent to which double-digit inflation has eroded nominal values, restrict policymakers’ response to events for fear of creating further economic turbulence. The recent drama in Washington about the debt ceiling again gives testimony to a wider problem. High debt also acts as a deadweight when it comes to growth, with high taxation being the poor substitute to ensure elevated government spending can continue. Such factors help account for market sentiment being very negative. However, these factors are largely known – they are part of the equation. History suggests it is at such times, when markets are fearful, that investors should buy.

The valuations of certain sectors reflect this poor sentiment more than others and therefore perhaps represent the better opportunities. The UK market stands at a historically wide discount relative to peers at a time when the new investment landscape should provide at least a modest tailwind given its composition. The private equity sector also looks attractive given the extent of the discounts to be found and the expertise and track record of management. The discounts are more than compensating for expectations that net asset values (NAVs) will come under pressure given the wider economic scenario – expectations that underestimate the managers’ cautious valuations, as seen when investments are realised.

Accordingly, since the beginning of the year, the companies listed below are further examples (in addition to those highlighted in last month’s column) of those bought for one or more of the 10 real investment trust portfolios managed in real-time on the website www.johnbaronportfolios, including the two covered in this column.

Private equity

Abrdn Private Equity Opportunities (APEO) invests predominantly in private equity funds globally, but has a European focus, with US holdings accounting for around 20 per cent of the portfolio. The company has handsomely outperformed the FTSE All-Share over both the short and long term. It has a broadly balanced exposure across the technology, healthcare, industrials, financials, consumer discretionary and staples sectors, and focuses on the mid-cap space where competition tends to be less intense. The board has delivered a progressive dividend policy, which this year suggests a yield exceeding 3.7 per cent when bought. A discount of over 42 per cent relative to the company’s last reported NAV adds to the investment case.

Apax Global Alpha Ltd (APAX) invests predominantly in private equity funds globally, but with a bias towards the US, while also holding debt and equity investments. The company has proven expertise covering four core sectors - technology & digital, services, healthcare and the internet/consumer. The company also pursues an attractive dividend policy, which distributes 5 per cent of its year-end NAV. As such, the company was yielding 7.0 per cent when bought (based on last year’s dividend of 11.82p) – the yield being helped by the company standing on a 30 per cent discount to its last reported NAV.

NB Private Equity Partners (NBPE) boasts a good track record while again standing on a c30 per cent discount to NAV when bought. The team focuses on the technology, healthcare and consumer/ecommerce sectors, predominantly in the US – the emphasis being on businesses that are expected to benefit from long-term structural growth trends. The portfolio consists of direct investments, which can make for slightly more volatility when compared with those trusts that invest in funds. There is also some gearing courtesy of its zero-dividend preference shares, which can enhance returns, particularly in rising markets. The company distributes 3 per cent of its NAV by way of a semi-annual dividend.

Equities – UK and overseas

Murray Income Trust (MUT) seeks a meaningful level of income and capital growth from a portfolio mostly invested in UK companies. The team is not deterred from taking meaningful positions – the top four holdings representing c20 per cent of the portfolio. The company has a sound record under Charles Luke, its respected lead manager – a NAV total return of 40 per cent compares with 28 per cent for the company’s benchmark, the FTSE All-Share index, over the five years to 31 March. However, shorter-term performance has been somewhat lacklustre, as has dividend growth given the extent of revenue reserves, but recent progress suggests things are turning up.

Henderson Smaller Companies (HSL) has a good long-term track record, having consistently outperformed the company’s benchmark in most years since its respected lead manager Neil Hermon took over the portfolio in 2002. Neil looks for quality businesses with good growth prospects, sound finances and strong management, which are attractively priced. Turnover tends to be low – stocks are typically held for five years and more. The name can mislead – the team defines smaller companies as any company outside the FTSE 100 index. As such, around half the portfolio consists of mid-cap stocks, with the balance consisting of small-cap and Aim stocks. The company stood on a discount of 14 per cent and yield of 3.0 per cent when bought.

AVI Global Trust (AGT) is a global generalist company that pursues a value, high-conviction mandate courtesy of businesses that offer good prospects for growth, but which stand on attractive valuations relative to asset values. The look-through discount, consisting of both the portfolio and company discount, is around 40 per cent, which is wide on both an absolute and historical basis. The top 10 holdings represent around 60 per cent of the portfolio. Recent figures suggest around half of the portfolio consists of family-controlled holding companies, with Japanese asset-backed companies and closed-end funds making up the difference.

Outside of Japan, the company’s regional breakdown reflects its assessment of comparative valuations, with 35 per cent of assets invested in Europe (including the UK), 30 per cent in North America, and 15 per cent in Asia/Emerging Markets. Given its underweighting of the US and value focus, AGT has performed well relative to both its MSCI ACWI ex US benchmark and the MSCI ACWI index (which includes the US) over the years. In addition, Japan remains a favoured overseas market, while the company’s relative performance may improve further given the changing investment landscape and the real possibility overseas markets may start to catch up with the US given the latter’s outperformance in recent years.