Welcome to the second issue of Investment Trust Quarterly.
This edition of ITQ begins with a review of sector growth and 2019 market events such as the Woodford saga that highlight the strengths of investment trusts. Next, Paul Niven of F&C Investment Trust, launched in 1868, tells how the trust structure helps him invest in private equity. He also offers his views on the global equities markets and the battle between ‘value’ and ‘growth’. Fidelity Japan Trust’s Nicholas Price reflects on recent movements in Japanese equities and outlines why he has been adding to his collection of out-of-favour tech stocks. Meanwhile, Fidelity Special Values' Alex Wright explains how he is navigating the UK stock market by looking for firms with strong balance sheets, a self-help story and a relevant offering. Finally, Simon Gergel of The Merchants Trust explores why Brexit uncertainties might be creating ‘value’ opportunities in the UK equity market. The permanent capital available to investment trusts supports a long-term view that might allow investors to take advantage of shorter-term market ‘irrationality’. We hope you find our supplement thought-provoking, especially in terms of the potential strengths of investment trusts in this bumpy, late-cycle environment.
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Contents
Where next after record 2019? Decoding equity markets Japan’s next tech leaders
Where next for investment trusts after a record 2019?
Looking through a long-term lens: Can investment trusts help decode today’s markets?
Fidelity: A diverse range of investment trusts
Long-term lessons for 2020 in UK equities
Japan’s next wave of tech leaders
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nvestment trusts were first launched as a vehicle over 150 years ago. But the advantages of the investment trust structure for long-term and illiquid investment strategies are proving very attractive in today’s fast-evolving markets.
Capital is at risk. The value of an investment is dependent on the supply and demand for the trust’s shares rather than its underlying assets. The value of the investment will not be the same as the value of the trust’s underlying assets. Past performance should not be seen as an indication of future performance. The views and opinions expressed in this article by the author do not necessarily represent those of BMO Global Asset Management. This financial promotion is issued for marketing and information purposes only by BMO Global Asset Management in the UK. F&C Investments Trust Plc is an investment trust and its Ordinary Shares are traded on the main market of the London Stock Exchange. English language copies of the key information document (KID) can be obtained from BMO Global Asset Management, Exchange House, Primrose Street, London EC2A 2NY, telephone: Client Services on 0044 (0)20 7011 4444, email: client.service@bmogam.com or electronically at www.bmogam.com. Please read before taking any investment decision.
BMO Global Asset Management (F&C Investment Trust)
Fidelity
The value of investments can go down as well as up and you may not get back the amount you invested. Past performance is not a reliable indicator of future returns. Overseas investments are subject to currency fluctuations. Some of the trusts invest more heavily than others in smaller companies, which can carry a higher risk because their share prices may be more volatile than those of larger companies. The shares in the investment trusts are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trusts can gain additional exposure to the market, known as gearing, potentially increasing volatility. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Investors should note that the views expressed may no longer be current and may have already been acted upon. The articles about Fidelity's trusts are issued by Financial Administration Services Limited, authorised and regulated in the UK by the Financial Conduct Authority. Fidelity, Fidelity International, The Fidelity International logo and F symbol are trademarks of FIL limited. UKM1219/25058/SSO/NA
Allianz Global Investors (The Merchants Trust)
All sources Allianz Global Investors GmbH unless otherwise noted. This is no recommendation or solicitation to buy or sell any particular security. A security mentioned as example in the article will not necessarily be comprised in the portfolio by the time this document is disclosed or at any other subsequent date. Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors may not get back the full amount invested. Past performance is not a reliable indicator of future results. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer and/or its affiliated companies at the time of publication. This is a marketing communication issued by Allianz Global Investors GmbH, an investment company with limited liability, incorporated in Germany, with its registered office at Bockenheimer Landstrasse 42-44, D 60323 Frankfurt/M, registered with the local court Frankfurt/M under HRB 9340, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht (www.bafin.de). Allianz Global Investors GmbH has established a branch in the United Kingdom, Allianz Global Investors GmbH, UK branch, which is subject to limited regulation by the Financial Conduct Authority (www. fca.org.uk). The Brunner Investment Trust PLC is incorporated in England and Wales (Company registration no. 226323). Registered Office: 199 Bishopsgate, London, EC3M 3TY. AdMaster 1015106
Opportunity from uncertainty
p4 Where next for investment trusts after a record 2019? p8 Looking through a long-term lens: Can investment trusts help decode today’s markets? p14 Japan’s next wave of tech leaders p16 Fidelity: A diverse range of investment trusts p18 Long-term lessons for 2020 in UK equities p20 Opportunity from uncertainty
structure for long-term and illiquid investment strategies are proving very attractive in today’s fast-evolving markets.
Some investment trusts have benefited from the silver lining in the cloud, as the falling pound has lifted the share price of some FTSE-100 listed companies which have exposure to overseas earnings
The B word From one saga to another, Britain is still struggling to lay the ground-work for an orderly exit from the European Union. UK equities have been shunned by global investors, with the consensus allocation 30% net underweight to UK stocks.(4) In the face of the uncertainty, the value of the pound tumbled against the dollar and the euro. But, again, some investment trusts have benefited from the silver lining in the cloud, as the falling pound has lifted the share price of some FTSE-100 listed companies which have exposure to overseas earnings. “UK equities are still clearly pretty unloved by international investors, although with the slide in the pound pushing the FTSE 100 upwards, it has become a bit ‘bad news is good news’,” said Godfrey. “The majority of this rise is coming from companies with a high level of foreign earnings, so there may be decent opportunities in UK domestic companies which are very out of favour.” Marten & Co founder and head of investment companies research James Carthew said overseas earnings have “definitely” been helpful to performance. "If you're in the camp that believes we're suddenly about to get a Brexit deal that sticks, you do run the risk of that reversing. But, against that, you also may see domestic UK stocks respond positively.”
t’s been a record-breaking year for investment trusts as a negative industry news story showed closed-ended funds in a more positive light. Figures from the Association of Investment Companies (AIC) revealed investment company assets doubled in the last six years to pass the
£200bn mark for the first time at the end of July, although total assets had dipped to £197bn by the end of October.(1) Asset growth has been driven by appetite for alternative investments such as property, private equity and infrastructure, illiquid assets which find a 'natural home' in investment companies, said AIC chief executive Ian Sayers.(2) The question of liquidity and the structural advantages of trusts has been thrown into sharp relief by the biggest financial news story of the year – the suspension and wind-up of the Woodford Equity Income fund (WEIF). Manager Neil Woodford hit trouble when his illiquid collection of unquoted companies became too large a part of his £10bn portfolio. When there was a run on the fund, Woodford was forced to suspend while he tried to sell holdings to meet redemptions.
Investors are now hesitating to jump in with both feet on hot growth stocks
A report by Investment Week
Sources: (1) Association of Investment Companies industry overview, 31 October 2019; http://bit.ly/2q7dMYF (2) Association of Investment Companies press release 12 August 2019; http://bit.ly/2ND2BA3 (3) AJ Bell, Investment Trusts Outperform Equivalent Funds, 15 July 2019; http://bit.ly/2qNYyYQ
*Source: AIC
Welcome
Value in trusts
Looking through a long-term lens
Japan's next wave
Fidelity’s range of investment trusts
Lessons for 2020
Contagion effect Edison investment companies analyst Sarah Godfrey noted that, while the publicity around Woodford may have damaged public confidence in investing, it does not damage the case for using a closed-ended fund to hold illiquid assets. This is despite Woodford’s Patient Capital trust suffering contagion as the Equity Income fund imploded. “Fundamentally, Patient Capital’s problems arose as a result of problems at WEIF, which if anything does more to underline the unsuitability of open-ended funds for holding illiquid assets,” she says.
Value versus growth The style argument of value versus growth is a perennial one, and global value has now underperformed global growth for more than a decade, far longer than at any other point in the last 45 years. “Unless you believe that it really is ‘different this time’, then at some point this will reverse,” said Godfrey. In that event, value-type or more broadly contrarian funds could do well. Some of these trusts have produced low single-digit returns at best over the past 12 months, and most are on discounts above the average for the AIC universe, Godfrey said. But the danger is that if underperformance goes on for too long, investors and indeed boards may begin to lose patience. Over the summer, there was a ray of hope for value investors when the strategy suddenly began to deliver again, but it was short-lived, said Carthew. He noted that speculative growth stories getting ahead of themselves in valuation terms was once the catalyst for a value rally. However, this does not seem to be the case now as investors generally are becoming more wary of hot growth stocks with little to back up their IPO prices. “People are becoming much less tolerant of companies that don't make any money and it's quite hard to see when they're going to make any money,” Carthew said, highlighting WeWork’s failed IPO, and disappointing market debuts for Uber, Lyft and Peloton. “The ‘close your eyes and jump in with both feet because it's growing’ mentality is gone for now,” he said. “In 2000, that was the signal for the tech bubble to burst, then growth and value completely switched places and there was a huge value rally. I'm not convinced we're about to see that now.” One of the main reasons growth looks good while value is not working is the macro environment of QE, low interest rates and low inflation, and there is no sign this is about to change, he added. Investors seem to feel the same, with a Bank of America Merrill Lynch fund manager survey earlier this autumn revealing just 7% expect value to outperform growth over the next 12 months.(5) This year, investment trusts have largely managed to navigate a torrid period for the industry, while reminding investors of the many benefits of the investment trust structure. But boards and managers will perhaps be hoping for a slightly less eventful 2020.
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Redemption pressures Investment companies are better suited to holding unlisted stocks because their structure means managers do not have the same pressures of dealing with inflows and outflows. Instead of issuing new fund units or cancelling them in response to investor demand, trusts issue a fixed number of shares and then trade on a discount or premium to net asset value depending on whether investors are buying or selling. This means managers can take a long-term view on less liquid assets that may take longer to trade. “I think there will be more interest in investment trusts as people recognise the protection of inflows and outflows that investment trusts have,” said Nick Greenwood, senior fund manager at Miton, who holds investment trusts in his portfolios. “Post-Woodford, in the short term people will just be nervous about everything but, longer term, they will recognise the strengths of investment trusts.” Laura Suter, personal finance analyst at AJ Bell, said investment trusts have been generally more underused than funds so “it is a good time to highlight the benefits particularly for those alternative or illiquid assets.” AJ Bell’s research has found trusts typically beat open-ended funds in terms of cost and performance.(3) It looked at portfolio managers running a similar strategy fund and trust to see how the two compared. It found that the trust outperformed the fund in 75% of cases on a total return basis over a 10-year period. Plus, the trust was the cheaper vehicle 60% of the time, with a lower ongoing charges figure. However, it also found that trusts were more volatile 90% of the time. The reason for this was their gearing, meaning their ability to borrow money. This is another important benefit of the investment trust structure, as it can boost returns but, equally, must be handled with care as leverage can also amplify losses. This could be a particular concern during periods of late-cycle volatility, when geared trusts could be more exposed to market falls. “Investors don’t get this extra performance for free and they have to be prepared for a bumpier ride,” Suter added.
Sources: (4) & (5) As reported in September 2019; see Rob Langston, Recession Fears Remain High Among Fund Managers, BAML Survey Shows, 18 September 2019; http://bit.ly/2CDHKX8
Where next for investment trusts
Investment company industry total assets passed the £200bn mark this summer (2)
Growth in alternative assets in the investment company industry (2)
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“People are becoming much less tolerant of companies that don't make any money and it's quite hard to see when they're going to make any money,” Carthew said, highlighting WeWork’s failed IPO, and disappointing market debuts for Uber, Lyft and Peloton. “The ‘close your eyes and jump in with both feet because it's growing’ mentality is gone for now,” he said. “In 2000, that was the signal for the tech bubble to burst, then growth and value completely switched places and there was a huge value rally. I'm not convinced we're about to see that now.” One of the main reasons growth looks good while value is not working is the macro environment of QE, low interest rates and low inflation, and there is no sign this is about to change, he added. Investors seem to feel the same, with a Bank of America Merrill Lynch fund manager survey earlier this autumn revealing just 7% expect value to outperform growth over the next 12 months.(5) This year, investment trusts have largely managed to navigate a torrid period for the industry, while reminding investors of the many benefits of the investment trust structure. But boards and managers will perhaps be hoping for a slightly less eventful 2020.
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What does Paul Niven think F&C Investment Trust's 151-year history tells us about investment trust structure? First, that investment trusts are a robust structure from which to create an investment or savings vehicle – one that’s survived two world wars, numerous recessions, the Great Depression, the inflation shock of the 1970s and the global financial crisis. That testifies to the benefits of independent legal status, shareholders and an independent board. But the fact that we're still thriving also shows the willingness of the board through time to embrace change. When we started out in 1868, we were called the Foreign & Colonial Government Trust because we invested in foreign and colonial bonds – at a time when the US and Canada were essentially emerging markets. The original purpose of the trust was to provide the investor of moderate means access with the same opportunities as the large capitalists of the day. And we started out as, essentially, an emerging market bond portfolio because interest rates were very low in the UK 150 years ago and savers were looking for yield pick-up. Sounds kind of familiar. But quite quickly we started investing into credit, then equities in the 1920s, and private/unlisted equities in the 1940s. By the 1960s, we were about 95% invested into equity markets. And that was critical if you think about the 1970s inflation shock – if you were a bond holder, you would have lost considerable capital. So the ability to change through time is critical.
What is driving the recent popularity of investment trusts? In part, asset growth in the investment trust space is linked to a rise in interest in alternatives. The closed-ended nature of investment trusts makes them a natural home for illiquid or long-term investments. Managers don't have to deal with inflows or outflows, so there's a pool of capital and you can take a very long-term view. Some of the growth has been income-focused partly because interest rates have been very low and people are looking for alternative sources of yield. But assets have been growing in the equity space, too. I think this relates to the increasing recognition of the advantages the trust structure brings, evidenced by often superior outcomes relative to comparable open-ended funds.
What is your own approach to gearing? Our gearing levels are about 7% at the present time, or reasonably modest by historic standards. We can borrow up to 20% of net assets so we're at the lower end of the range. The level of gearing is important but so is the spread of borrowings. If you invest in a portfolio of illiquid assets but have very short-term borrowings, you're mismatched on liquidity. The trust might not be able to get refinancing – a real issue, clearly. So we've got a broad spread of maturities from short term – one to 12 months – to borrowings that extend out to about 40 years. That very diversified borrowing reduces our refinancing risk.
We asked Paul Niven of F&C Investment Trust – the world’s oldest collective investment scheme – about the advantages of a long-term mindset, the art of late-cycle gearing, and the latest tussle between ‘value’ and ‘growth’
We have created a dividend every single year since we were listed in 1868 – no other listed company in the UK has paid a dividend as consistently as we have
What do you like most about your work? The sheer breadth of issues that I get to look at, particularly at F&C Investment Trust: macro trends, geographic, sectoral, style, as well as stock considerations. Also, most fund managers do not interact much with underlying investors because intermediaries play a big role. At F&C Investment Trust I get a chance to see retail investors at the Annual General Meeting and other events. You get a real sense of the value and worth of what you do and how the good decisions that you make, hopefully, impact on the finances and lives of individuals.
Where do you sit in the value-versus-growth debate? In contrast to some of our competitors, we have not nailed our colours to the mast as being an out-and-out growth fund or an out-and-out value fund. That said, we have had a bit of a growth tilt in recent years and that's been beneficial. Growth as a style has been in the ascendancy for the last decade. But value investors are strongly suggesting that the turn will now come for cheaper stocks. I think you have to acknowledge that the growth trend has run pretty far and valuations of some of the big growth stocks are looking a little bit full so the picture may become more balanced going forward. But for a sustained turn towards value, interest rates will probably have to be on a rising trend. More fundamentally, the idea that value stocks look cheap is based upon historic comparators that have some form of mean reversion built in. Value investors are assuming that their industries, or their stocks, are not fundamentally challenged on an ongoing basis. A stock might look cheap but if the earnings are not growing particularly strongly, it doesn't necessarily reflect value. You need to think about the value of the business in a more holistic sense, rather than the simple P/E and income yields a lot of investors look to.
You see yourself as a long-term investor but what does that mean and what difference does it make? It is a very interesting point. We are long-term investors in the sense that we've been running a long time and made our first equity investments in 1925. We invested in Shell in 1925 and still own that company today. But a long-term mindset does not mean that you hold on regardless. For us, 'long-term' is about delivery of long-term returns for shareholders as much as it is about dealing with companies and management on a long-term basis. We do engage with companies on a long-term basis but the approach is variable across underlying strategies. For example, our private equity portfolio is clearly long term because we expect to hold those positions for more than a decade. On the listed side, the holding period will vary, depending on the way the manager runs the underlying portfolio. Here's a couple of examples. We invested in Amazon in 2006 when it was trading in $30s. It's now about $1,800 so we've held that stock a long time and it's done well for us. Facebook we invested in through private markets in 2005 when it was a $100 million company and Mark Zuckerberg was only 21. We made 380 times our money on that investment prior to listing and it is now a $500 billion company.
We invested in Amazon in 2006 when it was trading in $30s. It's now about $1,800 so we've held that stock a long time and it's done well for us
Can you name one way for investors to improve their view of global equity markets? It’s a good idea to look at equities through different lenses. If you buy Apple, then you can think of that as a US company; as a technology company, supplying consumer goods; as a growth company, perhaps; or some people might actually view it as a value company. So the domicile, the sector, and the style of underlying holdings is something that you need to consider. A lot of people talk about US equity markets, especially, being expensive. The reality is that when you're buying the US equity market, you're buying a very, very different basket of shares than if you buy into the UK or European market. The US market has an inherently higher weighting in technology and related industries. It's a much more growth-heavy market than Europe, which has more cheap financials and banks. So geographic preferences are related to sectoral preferences, which are related to style preferences, and factor preferences. You need to think beyond the headlines and broad monikers when allocating capital. A lot of managers talk about themselves as ‘bottom up’ stock pickers. But if the ‘best’ stocks are all picked from one particular area like technology, or from a particular geography, you're taking a very specific style or regional decision. That is critical in terms of understanding likely outcomes and risks.
Gearing levels at investment trusts have to be managed appropriately as they can exacerbate losses in a declining market
So you have the flexibility to adjust the tilt of the portfolio if you wanted to, as markets evolve? Yes, exactly, the market has cycles: momentum or growth tends to work for a long period of time, then won't work as well. Value works for a period of time, and then won't work for a period of time. We position the portfolio so we've got some tailwinds that work over the longer term, balanced towards momentum or growth, value and quality, depending upon how we view the cycle.
We look for private equity opportunities unavailable in the public market space with a focus on mid-market opportunities. The growth opportunities are higher and the pricing better
Is your glass half full or half empty on global equities? Half full. One of the big questions investors need to answer is whether there will be a recession or not – more specifically, sustained earnings contraction. And my sense is that we're going to remain at a sufficient level of growth to avoid slipping into, importantly, a US recession. If you've got that view, then equity markets should do reasonably well. Valuations are not cheap but we might hope for earnings growth to get back on a more positive trend in 2020. Longer term, I think equities continue to offer relative value compared to other asset classes. Those really bearish on valuations make many assumptions about mean reversion in margins, profitability and earnings that may prove to be misplaced. One reason is that competition has been declining in almost every industry we can see. Bigger players have become more dominant and across virtually every sector of the economy there's a much higher proportion of sales revenues from the top four or top 10 companies than was true 10 or 20 years ago. These larger firms are also more dominant in terms of employment. One curious anomaly in recent years is that the labour market has been tight but wage pressures low. Partly that's because employees have got fewer options in terms of employers, so owners of capital are likely to continue to do relatively well at the expense of labour. That creates huge issues for society in terms of winners and losers; long term maybe something has to change. But in the short to medium term, I don't think that there's sufficient will to change those trends.
How do you differentiate yourselves from other trusts? First, we make full use of the advantages a trust structure provides, for example, we've got a very long history of investing into unlisted private equity markets. Some other trusts do that in the global growth space but not many. It means F&C Investment Trust provides a one-stop shop for investors looking for a diversified global solution with access to listed and unlisted equity markets and therefore growth assets. Second, we can use strategies and fund managers within BMO but also third-party managers to access opportunities – an unusual blend of internal and external. Third, scale is also important. If we are talking to intermediaries like wealth managers, many of those wealth managers will not look at investment trusts below a certain size because they need liquidity. We can provide that liquidity. The broader point is that when you make any investment you have to think about the appropriate investment horizon, particularly if you're dealing with illiquid underlying assets. Trusts trade on a daily basis and you get a ticker, but that doesn't mean there's always a lot of liquidity in the stock. Therefore the size of the trust is important.
What else do advisers and wealth managers need to keep in mind when investing in trusts this late in the cycle? One obvious point concerns gearing, because trusts can borrow to invest. In rising markets, gearing tends to accentuate returns and if markets decline, it tends to exacerbate losses. The gearing levels of the trust have to be managed appropriately because if you're highly geared in a declining market it can also lead to breach of covenant in terms of lenders. That's clearly serious. Also the trust share price is a function of supply and demand and may diverge from the underlying net asset value (NAV), generating a premium or a discount. In times of stress, you will not suffer gating, which you could in an open-ended fund, but you may only be able to deal at a price further from the NAV than you would like.
How do you balance the goals of capital growth versus income? Our overriding objective is long-term growth in both capital and income. On the latter point, we have created a dividend every single year since we were listed in 1868 – no other listed company in the UK has paid a dividend as consistently as we have. We've paid rising dividends in each of the last 48 years. We're not a high yielding company – our yield is about 1.6% – but our shareholders look to us for consistent rises in income which exceed inflation through time. That's a key objective for the Trust. However, one of the benefits of an investment trust structure is that you can put aside revenue in the good times. That means that we can provide income in leaner times when revenues are not as strong. It also means that we don't have to sacrifice capital in order to deliver income. By contrast, many income investors have performed poorly recently because they've been chasing income for its own sake. The right way to approach investments in my view is to focus on total return and then distribute in a manner appropriate to your shareholders.
Is global diversification an important part of your offering to investors? We are 90-95% plus retail owned. Most of those investors are not assembling a whole range of funds to balance out portfolio exposures. So we are providing a service to them. They entrust us with the important decisions of where to invest across listed equities and private equity in terms of regions, sectors, styles, managers, etc. Our shareholders do not expect us to place all of our capital on one potential outcome, e.g., growth or value, Japan or the UK. They expect us to adopt a conservative and diversified approach.
Do the big strategic decisions at the trust rest with you personally? I'm the lead manager but the board is ultimately responsible for the long-term trust strategy and I work very closely with them to lay out, articulate and agree that strategy: Where we invest, how we invest and so on. Structural gearing decisions also rest with the board but, again, I work very closely with them. The day-to-day management of the portfolio is down to me, really. A good example of how it comes together is private equity. We've got a long history in private equity but we stopped committing to our third-party managers in 2008. I got involved with the trust in 2014 and I proposed, and the board agreed, that we should recommit to private equity. Then it was down to me to go and find the right partners and deals. Private equity has a tremendous amount of capital allocated to it with a lot of that capital chasing the big deals. So we look for opportunities unavailable in the public market space with a focus on mid-market opportunities. The growth opportunities are higher and the pricing better.
Any ‘red flag’ issues out there that might make you rethink your stance on global equity markets? The US national account data is presenting more of a slowdown in corporate earnings than the US listed corporate sector. One reason for this anomaly might be that listed companies are more adept at manipulating reported earnings. That's a concern because you're then buying stocks on the basis of a bit of a fantasy, in terms of the earnings backdrop. The other potential explanation relates partly to the competition issue we just discussed, in the sense that national data reflects the whole economy. It might be that listed companies are taking market share from unlisted companies, which tend to be smaller. But squaring that circle remains an issue, going forward.
Range of investment trusts
Local Chinese brands have started to move into more upmarket streetwear and have been able to command premium prices
Semiconductor opportunities In this environment, market dynamics combined with overly negative sentiment have created opportunities to buy companies at trough valuations. Notable examples held in Fidelity Japan Trust PLC include Tokyo Electron, which makes semiconductor production equipment, and Screen Holdings, which specialises in manufacturing and cleaning systems for semiconductors and flat panel displays. Both of these companies rank among the trust’s largest active stock weights. As the inventory cycle of electronic components and devices bottoms out, a number of globally competitive companies are well positioned to capture the structural growth for automotive semiconductors. For example, Renesas Electronics (the largest microcontroller semiconductor company in Japan) and Rohm (a global leader in power management ICs and devices) stand to benefit as content per car increases alongside the development of CASE (connected/ autonomous/ shared/ electric) technologies. Meanwhile, the advent of 5G handsets will create a new content cycle for globally competitive component makers even if the overall economic environment is not accelerating. For example, our meetings with supply chain companies suggest that 5G penetration will be higher than street estimates. Companies such as Murata Manufacturing, a global leader in capacitors and communication modules that is held in the trust, are likely see an increase of around 50% in content per unit for 5G smartphones. Similarly, battery and component maker TDK will benefit from the higher power usage required in 5G phones. Among these more economically sensitive parts of the Japanese market, the trust’s overweight exposure to technology-related areas is counterbalanced by an underweight positioning in automobiles, especially large original equipment manufacturers (OEMs). In addition to a tough sales environment, increasing investment in electrification strategies – in order to minimise the impact of tighter environmental regulations – is also weighing on many automakers’ earnings. Against this backdrop, I view some of the above-mentioned producers of parts and components that will benefit from rising content per vehicle as more attractive investment opportunities with greater upside potential.
Japanese equities have faced several external headwinds over the last 12 months which have clouded the outlook for corporate earnings. Fidelity Japan Trust PLC’s Nicholas Price reflects on recent market movements and outlines how and why he has been adding to out-of-favour tech stocks
J
apanese companies have faced multiple headwinds over recent times as uncertainty over US-China trade frictions and the impact on the global economy have clouded the outlook for corporate earnings. While we have seen something of a recovery in markets year-to-date – with the
broad TOPIX Index rising by double digits in GBP terms over the first 10 months of the year – it is notable that the Japanese market has lagged its global peers (excluding the UK) over the last 12 months. Periods of market weakness have created some interesting opportunities among individual stocks and sectors, particularly in areas relating to technology, where there have been opportunities to capitalise on disconnects between near-term sentiment and mid-term fundamentals. Trade frictions coincided with a downturn in the technology cycle, and we saw, for example, semiconductor stocks falling by 50% relative from the peak in late 2017. As we come out of a negative inventory and supply cycle and memory prices stabilise (NAND in the second half of 2019 and DRAM in the first half of 2020), earnings should bottom out in the next quarter or two. Looking into 2020, we can expect a reacceleration of demand for memory semiconductors, driven by content growth from the global rollout of 5G smartphones and a recovery in spending by data centres. Memory supply-demand will tighten as new capacity additions had been controlled over the past one to two years.
Nicholas Price has over 20 years of investment experience in Japanese equities, having joined Fidelity’s Tokyo office in 1993 as a research analyst before becoming a portfolio manager in 1999. He currently manages a number of Japanese equity portfolios for both retail and institutional clients, using a consistent growth at a reasonable price (GARP) investment style. He has managed Fidelity Japan Trust PLC since September 2015. Nicholas graduated from Cambridge University with a BA in History and International Relations and has an MA in Japanese from Keio University. He is fluent in Japanese and is permanently based in Tokyo.
Despite staging a recovery in recent months, Japanese equities have lagged their global peers (excluding the UK) over the 12 months to end-October.
Key points
The period of market weakness in late 2018 created some interesting opportunities among individual stocks and sectors, particularly in areas related to technology.
Fidelity Japan Trust PLC has exposure to a number of companies that are well positioned to benefit from a recovery in demand for semiconductors and other electronic components.
A diverse range of investment trusts
Fidelity Special Values PLC
Trust objective The investment objective of the Company is to achieve long-term capital growth primarily through investment in equities (and their related securities) of UK companies which the manager believes to be undervalued or where the potential has not been recognised by the market.
Manager’s investment approach Alex Wright favours companies which are likely to have already gone through a sustained period of underperformance, but the risk of further downside is limited. There are two main pillars to his approach: (i) Alex looks to invest in companies that have exceptionally cheap valuations or some kind of asset that should stop their share prices falling below a certain level. (ii) Alex looks for events that could significantly improve a company’s earning power, but are not currently reflected in the company’s share price.
Fidelity China Special Situations PLC
Trust objective The investment objective of the Company is to achieve long-term capital growth from an actively managed portfolio made up primarily of securities issued by companies listed in China and Chinese companies listed elsewhere. The Company may also invest in listed companies with significant interests in China.
Manager’s investment approach Dale Nicholls believes that the best investments are in companies with good long-term growth prospects, which are cash generative and are controlled by strong management teams. Ideally these factors are underappreciated by other investors and not reflected in valuations. Dale’s search for unrecognised growth leads to a preference for small and mid-cap companies. These segments tend to be less well researched and offer more mispricing opportunities. Risk management is a key part of Dale’s process and he places significant emphasis on company meetings in order to fully understand their corporate strategy and monitor their progress.
Fidelity European Values PLC
Trust objective The investment objective of the Company is to achieve long-term growth in both capital and income by predominantly investing in equities (and their related securities) of continental European companies.
Manager’s investment approach Sam Morse believes that dividend growers outperform consistently. This is because such companies are invariably healthy businesses with stable earnings growth potential and the ability to generate high levels of free-cashflow – all factors that should be rewarded by the stock market in the fullness of time. Utilising a clearly defined and repeatable bottom-up approach, he looks to build a relatively concentrated portfolio of European companies which he believes have the ability to grow dividends sustainably over a three to five year horizon. These are identified by four key characteristics: (i) positive fundamentals, (ii) cash generative, (iii) a strong balance sheet, and (iv) an attractive valuation.
Fidelity Japan Trust PLC
Trust objective The investment objective of the Company is to achieve long-term capital growth by investing predominantly in equities and their related securities of Japanese companies.
Manager’s investment approach Nicholas Price follows a ‘growth at reasonable price’ approach, utilising Fidelity’s extensive local and global research capability. He focuses on gathering information from multiple sources. A key pillar of Nicholas’ process is detecting signs of change which is summarised as: (i) a change in fundamentals, (ii) a change in environment, (iii) a change in sentiment, and (iv) change in valuations. He also maintains a strong sell discipline by naturally trimming outperformers and recycling into new ideas, retesting the mid-term growth thesis for signs of change and moving on if there are more attractive opportunities elsewhere.
Fidelity Asian Values PLC
Trust objective The investment objective of the Company is to achieve long-term capital growth through investment principally in the stock markets of the Asian region (ex Japan).
Manager’s investment approach Nitin Bajaj is a contrarian value investor whose investment decisions are based on rigorous fundamental analysis, with a bottom-up stock selection approach primarily making use of Fidelity’s proprietary research resources. There are three guiding principles in his investment process: (i) Understand the business: the economic characteristics of a firm’s underlying franchise. (ii) Valuation: anomalies, or opportunities to buy a good business at attractive valuations. Finally, (iii) Awareness of high expectations: stay away from the latest market fads.
Past performance is not a reliable indicator of future returns.
Fund launch
17 November 1994
£719m
Fund AUM
80-120
Holdings
0.92%
Ongoing costs
(ex-portfolio transaction costs)
FTSE All-Share Total Return
Comparative index
MSCI China
1.25%
120-160
£1,296m
19 April 2010
FTSE World Europe (ex UK)
0.88%
40-50
£1,124m
5 November 1991
TSE Topix Total Return Index
1.10%
80-110
£237m
15 March 1994
MSCI AC Asia Ex Japan
0.98%
100-200
£290m
13 June 1996
* Source: Morningstar as at 30.09.2019, bid-bid, net income reinvested. ©2019 Morningstar Inc. All rights reserved.
^ This is a comparative index of the investment trust. The value of investments can go down as well as up and you may not get back the amount you invested. Overseas investments are subject to currency fluctuations. The shares in the investment trusts are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trusts can gain additional exposure to the market, known as gearing, potentially increasing volatility. Some of the trusts invest more heavily than others in smaller companies, which can carry a higher risk because their share prices may be more volatile than those of larger companies.
Last month Fidelity Special Values PLC turned 25. With today’s market more focused than ever on the short-term, Alex Wright reflects on the investment trust’s success and draws out lessons for the future.
Becoming more defensive Staying focused on company fundamentals has not been easy in 2019. The political and economic environment has had a direct impact on companies, notably through fluctuating exchange rates and dampened investment confidence. Domestic uncertainty persisted against a backdrop of a weakening global economy, but stock markets rose to higher valuations in the expectation of more ‘easy money’ from central banks. Higher valuations but weaker fundamentals have meant that on a bottom-up basis, I have been able to identify more opportunities in defensive stocks in comparison to previous years. In fact, the portfolio today has a more defensive tilt than at any time over my tenure. The defensive stocks I own are not the ‘quality’ UK defensives seen by many as a safe haven, which trade at high valuations. Rather they are ‘hidden’ defensives – not part of the traditional defensive sector – or defensive businesses in which the market has lost confidence. Although a high-quality company, DCC is a logistics business sitting in the capital goods sector, so many investors overlook its defensive characteristics. The company has an excellent track record in capital allocation, very little debt, and an appealing valuation at 6.5% free cash flow yield. A company that three years ago was regarded as high quality but today as structurally compromised is tobacco company, Imperial Brands. The stock yields 11.5%, indicating the market expects a dividend cut. However, our work suggests this view could be wrong. The dividend is comfortably covered by free cash flow and the management appear committed to the dividend policy.
A
mid today’s noisy media and political landscape, I have found it helpful to reflect on how for 25 years Special Values has delivered an extremely good compounded return for investors, with surprising consistency for a contrarian fund. Crucially, this has not been achieved
through correct predictions of political or macroeconomic events, but by adhering to contrarian, bottom-up stockpicking principles employed since the company was launched under Anthony Bolton’s management in 1994.
Source: * Fidelity International. The chart data shows the Fidelity Special Values PLC’s relative sector weighting vs the portfolio’s benchmark, which is the FTSE All-Share, as at 30 September 2019. The data is purely representative and sector weightings in the fund may vary. The comparative index is used for reference only. Holdings can vary from those in the index quoted.
Navigating the UK domestics It remains prudent to tread cautiously among UK domestic stocks, as structural issues facing some of these businesses mean they could be ‘value traps’. I look for businesses with strong balance sheets, a self-help story, and a relevant offering that should withstand structural challenge from disruptive market entrants. It is hard to ignore the effects of politics and economics on this part of the market, with UK retailers particularly exposed to sterling weakness as they buy goods overseas and sell in the UK. However, I do see selective opportunities in UK domestic stocks, and own positions among financials and consumer businesses. Among the retailers, Halfords has a business model which should be relatively well-protected from online disruption, as well as a new management team pursuing a self-help strategy. However, the company’s sensitivity to the macro environment, as well as limited liquidity, means Halfords is a small position, although one with considerable upside if things improve as we believe they might. Owning smaller positions in stocks with a large range of potential outcomes has been a consistent feature of the Special Values portfolio.
The value vs growth debate The value investment style has experienced a difficult 10 years since the financial crisis. Given that the performance of the value style is tightly linked to unpredictable macroeconomic events, it is difficult to make predictions as to when value might stage a recovery, although it would seem that this would require growth and interest rate expectations to rise from current levels. Many of the market’s most popular funds today have a distinct ‘growth’ bias. However, an investor who wants to be properly diversified should own a mixture of value and growth stocks in their portfolio, so as to be prepared for a range of future economic scenarios. Our style of value investing does not rely exclusively on the value style to drive returns, instead looking for stock selection to be the primary driver of performance.
Overall Among global stock markets, the UK stands out as cheap and unloved. However, the tail risk of a ‘no deal’ scenario appears to have reduced since Boris Johnson secured a deal in Brussels and the subsequent general election. While I am not banking on a ‘parting of the clouds’ moment, the worst-case ‘no deal’ outcome now seems significantly less likely. While fundamentals are not great in the UK, neither are they in many other parts of the world. And the UK has a low starting valuation and potential for a positive catalyst. I do not want to claim I have some insight into when this valuation gap could close. I continue to focus on what has driven Special Values since its launch 25 years ago: contrarian stock-picking.
Evolving sector exposure: moving increasingly ‘defensive’ since 2017 *
With around 18,000 listed companies across Asia, the opportunity to find hidden gems is immense but time consuming
Simon Gergel, fund manager at The Merchants Trust – celebrating its 130th birthday this year – looks back on a politically volatile year and tells us how the investment trust structure helps him take advantage of the irrational way that stock markets can behave
Photo by Mickey O’neil on Unsplash
We are near the end of an interesting year so can you recap on the key drivers? It's been a fascinating year and we've all had to get used to politics being a big driver of stock markets; everything from Donald Trump’s tweets to US/China trade relationships and the machinations of the Brexit process. The other big driver has been central bank policy. We started the year thinking interest rates might be going up in the States and possibly in the UK and now we're on a path where interest rates are coming down and economic growth is slowing. So we've had a big change in direction.
Larger stocks have tended to perform better than small and medium-sized companies. Why is this? Large companies in the UK tend to be very international and very global, so they have a large amount of their earnings coming from overseas. This means they're not affected by the risks and uncertainty over Brexit. The currency effect has also been quite strong. Sterling has been very weak so if you're earning money abroad, that money is more valuable to a UK investor as a result of the depreciation of the pound. The other factor is that as money has come out of the stock market – a lot of money has gone out of shares into bonds – that has had more of an effect on small companies. Liquidity has dried up and you have seen a number of cases where small company valuations have fallen very significantly, whereas large companies tend to be more liquid, more tradable, and have held up better.
Do you think the outlook for smaller companies is quite mixed? You've got to separate the outlook for companies and the way the stock market behaves. One of the opportunities as an investor is to identify where the stock market is being irrational, or not taking a logical view. Many small companies are perfectly good businesses with strong balance sheets. Many are global businesses that just happen to be listed in the UK. There are opportunities to take advantage of that, but you also have to be aware that liquidity can be more difficult in such a period. For an investment trust like Merchants Trust, liquidity is not really a big issue. We have permanent capital, we're never forced to make sales in the portfolio, so we can ride through periods of illiquidity. And we can pick up shares and know that we can own them for the long term – a great opportunity if markets are behaving slightly irrationally.
We can pick up shares and know that we can own them for the long term – a great opportunity if markets are behaving slightly irrationally
So the UK market now seems polarised in ways that offer opportunities? Polarisation is an interesting phenomenon. We've got a population that Brexit has polarised and the market is polarised between not only large companies versus small companies, but also between quality and growth versus value. So investors are uncertain but interest rates are coming down, forcing people to take money out of the bank and put it somewhere else; a lot of that is going into bonds. But where that money is going into equities, it's tending to go into what are perceived as being safer and higher quality businesses, such as the big food companies and relatively resilient businesses, and that's leading to many other businesses, perfectly good companies, being friendless, and finding very few investors. And you're seeing a huge polarisation of the stock market between these high quality, high growth companies which are on really high valuations now, and many other sectors which are actually really on very low valuations. That's providing great opportunities for markets but it is a really polarised environment.
Simon Gergel is looking for value in businesses with a good structure and outlook including aerospace companies
As an active manager looking after the Trust, how do you navigate all this? We try to maintain a very diversified portfolio. We have over 45 different companies within the portfolio. They're exposed to different end markets, different countries, different sectors, and different themes. But having said that, there's a great opportunity to take advantage of this polarisation and buy companies that are on very modest valuations where you've got a high dividend yield, decent dividend growth, and we can make attractive total returns in the medium to long term because the starting valuations are so modest. This year, for example, we've bought three new companies. They're all listed in the UK, because we invest only in the UK, but they all have big international operations, with a big exposure to emerging markets. One has got exposure in Africa, one has got a big exposure more broadly in emerging markets and one is quite exposed to Eastern Europe. And we see better growth in emerging markets than we see in the West and so we're able to buy good businesses with strong market positions on really attractive and sensible valuations, though the short-term volatility in the market means it might take a while for any returns to come through.
A value investor is somebody that tries to identify the underlying fundamental value of an investment and buy companies or assets when they are priced below that. There is a lot of evidence that if you buy cheap shares, on average, over the long term, you can deliver better performance. The other major style of investment is growth investing, where essentially you are trying to identify the best companies that you think can grow fastest. You may not worry too much about the price you pay, on the basis that if you pick the right companies, over the long term you can still make a very good return. We focus more on the value side, which does not mean we neglect the growth side; we do look at the growth of businesses and the fundamental quality, but we try and buy businesses only when they are trading below the fair value. There are two main ways we implement
one of the ways we do that is by buying companies with above-average dividend yield. Those tend to be companies that are a bit cheaper than average; dividend yield is actually a measure of value. The second more subtle way is within our investment process. When we look at an individual company, value is one of the three key pillars we look at. Pillar 1: So the first thing we look at is the fundamentals of the business: how strong the business is, how attractive an industry it is in, etc. Pillar 2: The other thing we look at is how well is the company positioned? What is changing in the environment – for example, with regard to the economic cycle or the firm’s industry – that gives that company a structural advantage? Pillar 3: But the third, and really important, thing is valuation. How does the value of this company compare to where it has traded in the past; how does it compare to other companies in the sector; and most important of all, how does the valuation compare to all the other companies we could buy in the market? We're looking to buy cheaper companies but also those that are good businesses. In particular we focus on cash flow because, ultimately, businesses are about generating cash.
value investing. The first is that we tend to buy high-yielding shares. Merchants Trust has grown the dividend every year for 37 years, and
How do we define value investing at The Merchants Trust?
In what sectors are you seeing companies with potentially underweight valuations? It's across the market, for example, in the financial sector, real estate, construction and building materials, the industrial sector, and some consumer sectors. I think the biggest undervaluation area is companies exposed to the domestic UK economy, whether that's retailers or travel and leisure companies. Some of those are risky businesses as well because there are some structural pressures. So you have to be very careful. It's not just about buying the cheapest stocks. It's about buying companies where they are cheap but they're still good businesses with a good structure and outlook. And therefore we're not necessarily buying purely domestic retailers, for example, but we are buying media businesses, construction companies, and aerospace and defence companies.
Companies focused on the UK might be most vulnerable to any ongoing Brexit-related uncertainty, so aren’t you therefore taking a bet? I would call it more of a balance. There is some exposure within the portfolio to companies and sectors that are exposed to the domestic economy and I think that makes sense. In the long term, there's every reason to think the UK economy can do absolutely fine in whatever scenario comes through. The bigger problem is the short-term uncertainty, which makes it hard for a business to plan. The other thing we're seeing though is international and other investors come in and buy companies off the market because of their attractive valuations. Even companies exposed to the domestic economy can be vulnerable if the valuation is too low.
Lastly, Merchants' objective is to pay a high and rising dividend along with an attractive total return but how confident are you of extending your 37-year dividend growth record? It's interesting that the underlying performance of many of the companies in the portfolio is pretty resilient at the moment, despite uncertainty in the stock markets. Trading is good, cash flows are strong, and dividends are coming through at a healthy rate. So when we look at the portfolio, we're seeing good income levels off a very high starting yield of well over 5% from the portfolio and we're seeing good dividend growth. The other thing that's helping dividends is the refinancing of the debt. Merchants has over the last 18 months significantly restructured its debt profile. It's brought the costs of debt down from over 8% to about 3.5% which is quite a big improvement. That really helps in terms of the money we can distribute to shareholders at lower cost of interest. So that's all pointing to a healthy picture for dividends at the moment.
To discover more about The Merchants Trust, visit merchantstrust.co.uk , where you can register for regular updates. This article is drawn from A Value View, Episode 10 – part of an ongoing series of podcasts
Simon Gergel, fund manager
