There is no better pooled investment vehicle than an investment trust over the long term. But some of the factors that account for their success, including their structure and ability to gear, are also those that contribute to their short-term volatility as discounts widen. Investment trust portfolios in particular should therefore maintain adequate cash levels and ensure the extent of diversification adequately reflects their place in the investment journey. But the choice of asset has rarely been more important when addressing the perception and reality of inflation at this point in the cycle.
Being selective
The last downturn was unusual in that it was largely caused by high debt rather than falling demand. In response, governments printed money and kept interest rates artificially low. Central bankers are claiming a great victory – even though they were cognisant of, and did little to correct, the evident financial imbalances that caused the problem. It is difficult to prove a counter-factual. Regardless, concerns about rising inflation are now surfacing as interest rates turn upward and markets adjust to a post-quantitative easing world.
Although equities usually do well during the early phases of any inflationary cycle, such concerns should necessitate careful thought about which asset classes to employ and the balance between them when seeking diversification. Artificially low interest rates have increased the correlation between certain types. Some traditional friends are perhaps today less worthy – some new ones perhaps more so.
Government bonds, the traditional choice, do not look good value. Higher yielding and decent quality corporate bonds still have a role to play for they will be better able to accommodate expectations of modestly rising inflation. Otherwise, other traditional safe havens, including gold, have tended to disappoint. Investors need to be selective.
In addition to the raising of cash levels, the focus of the gradual rebalancing of our portfolios after a good run has been toward those asset classes that will benefit from rising inflation, both directly or indirectly. Such rebalancing seeks to achieve both adequate and appropriate diversification.
The asset classes chosen include infrastructure and renewable energy, where prices have a near-defined correlation with inflation. Others include commercial property, asset finance and commodities, where the correlation is less defined but inflation nevertheless has usually provided a tailwind. Their different risk profiles are acknowledged by the portfolios’ relative weightings.
In addition, some asset classes will better reflect the reality of inflation, others the perception. Technology and the audacity of smaller company entrepreneurs will act as a restraint on the former, even though certain indicators will flash ‘red’. As such, some assets may respond more quickly than others to the vacillations of the perceived threat.
The good news is that, for various reasons, some of these less correlated assets remain attractively priced because of undue concerns of one sort or another – infrastructure because of possible policies from a Labour government, commercial property largely because of the possibility of a ‘no-deal’ Brexit, commodities because indicators suggest the global economy is slowing, and asset finance because of company-specific issues.
And depressed prices help make for attractive yields. As a measure of conviction, most of the eight real investment trust portfolios run in real time on my company’s website www.johnbaronportfolios.co.uk, including the two covered in this monthly column, have seen exposure increased to such assets over the year. This has helped certain portfolios achieve sustainable yields of over 5.5 per cent.
Portfolio activity
During October, the Growth portfolio sold its holding in JPMorgan Mid Cap (JMF) and top-sliced Templeton Emerging Markets (TEM) because of company-specific factors and for reasons of diversification. With the proceeds it added to its holding in BlackRock Throgmorton Trust (THRG) in part because of its excellent record. However, the majority of the monies raised wereused to increase exposure to existing holdings in HICL Infrastructure Company (HICL) and Standard Life Property Income (SLI). Prices achieved were £11.35, £6.49, £4.93, £1.55 and £0.89 respectively.
HICL provides a high level of inflation-linked returns (0.8 positive correlation) courtesy of its exposure to a collection of infrastructure investments at the lower end of the risk spectrum. The underlying investments have an average life of over 30 years. The company offered a yield of 5.2 per cent when bought.
SLI was added to because sector sentiment trails fundamentals and the company itself is attractively rated. This cycle’s lack of investment and therefore shortage of supply is resulting in rental growth, as the economy moves forward. Company debt levels are low with very few trusts now having any medium-term refinancing requirements. Add in managers’ caution and therefore lack of development exposure, their focus on ensuring dividends are covered, and their diversification across sectors and regions, and these trusts look attractive. SLI exemplifies this reality and offered a 5.3 per cent yield at time of purchase.
Meanwhile, during October, the Income portfolio also sold JPMorgan Mid Cap (JMG) and top-sliced its holding in Henderson Far East Income (HFEL) for the same reasons highlighted above. With the proceeds, SQN Asset Finance Income Fund (SQN) and Regional REIT (RGL) were added to, while AEW UK REIT (AEWU) was introduced. Prices achieved were £11.35, £3.36, £0.98, £0.99 and £0.93 respectively.
As highlighted when first introducing SQN to the portfolio in August at a price of £0.93, the company’s objective is to produce regular dividends and capital growth through investment in business-essential equipment and other physical assets. The company holds around 200 investments with an average size of around £8m, and its underlying investment yield of over 9 per cent covers the 7.25p dividend – representing a yield of 7.4 per cent when bought.
RGL invests in a diversified portfolio of secondary offices and light industrial sites in the principal regions of the UK outside the M25, in order to capitalise on the valuation and yield gap that exists between London and the regions, and between prime and secondary property. The company has recently reported good progress and an increased dividend, which equates to a yield exceeding 8 per cent at time of purchase. In addition, significant director buying suggests confidence.
AEWU seeks to capitalise on the pricing anomalies offered by smaller commercial properties on shorter occupational leases (averaging 4.9 years to break and 6.1 years to expiry) in strong commercial locations. An active asset management approach is then employed to improve income streams. The 8p dividend is now covered by earnings and represented a yield of 8.6 per cent at time of purchase. An experienced management team, a focus on the industrial sector, limited exposure to retail, a geographical bias outside the south-east and discount to the last reported net asset value of 100p adds to the attraction.
