The Edinburgh Investment Trust plc
ANNUAL FINANCIAL REPORT
FOR THE YEAR END 31 MARCH 2023
30 May 2023 – The Directors of the Edinburgh Investment Trust plc (“the Company”) have today announced the annual results for the period ending 31 March 2023.
Highlights
· Net Asset Value (NAV) per share (with debt at fair value) on a total return basis increased by 7.9%, comfortably exceeding the 2.9% return on the FTSE All-Share Index. The share price total return was 8.4%.
· Final dividend proposed of 6.7p per share. Dividends for the financial year +5.6% compared with the previous year, equivalent to a yield of 4.0%
· Net gearing at 31 March 2023 of 4.7%
· Share price discount to NAV narrowed marginally from 7.7% to 7.5%
· Since James de Uphaugh became Manager of the Company in March 2020, the cumulative NAV return of +65.9% and the share price return of +75.5% have outperformed the FTSE All-Share return of +47.4% (all in total return terms)
Elisabeth Stheeman, Chair, said: “It has been a great pleasure to lead the Company in my first year as the Chair of the Board. Together with my fellow Directors, and the Company’s Manager, we have continued to build on the strengthening investment track record to position the Company as a core holding for long-term savers.
“It has been another encouraging twelve months for the Company’s investment returns. Growth in both the NAV and the share price comfortably exceeded the FTSE All-Share Index. The NAV return in total return terms was 7.9% against the index return of 2.9%. We are therefore building a track record under the new Manager that meets the Company’s first investment objective – a long-term increase of the NAV per share in excess of the index.
“Despite the ever-uncertain economic outlook, there is enthusiasm about the underlying prospects for the stocks in the Company’s portfolio. The Manager’s approach of maintaining a diversified portfolio is therefore an important feature that should help protect shareholders’ capital over time. We believe the Company is well positioned to deliver to shareholders attractive total returns.”
James de Uphaugh, Manager, said: “It is now just over three years since we became the Manager of the Company. We took over in the midst of the market sell-off in March 2020, as the full implications of the COVID pandemic began to dawn. Since then, our investment approach has helped us deal with an at times rapidly changing economic and market backdrop. As it turns out, we became stewards of your portfolio towards the lowest levels of the market. Absolute returns have been strong since then.
“In terms of the main stock contributors over the last year, the top three were BAE Systems, NatWest and Centrica. These stocks encapsulate the diversified nature of the portfolio. Other contributions came from Greggs, Standard Chartered and Weir.
“The better recent returns from the UK equity market strike us as the early stages of a recovery in the market. This recovery is rooted in the undervaluation of UK equities that has built up over time and we remain optimistic about the specific prospects for the Company’s holdings.
“Overall, 2023 could see lower inflation, peaking interest rates and perhaps a slightly better tenor from the consumer. A balanced, diversified portfolio is as important as ever.”
The Edinburgh Investment Trust plc
ANNUAL FINANCIAL REPORT
FOR THE YEAR ED 31 MARCH 2023
Financial Information and Performance Statistics
| Year Ended | Year Ended | |
| Total Return(1)(3)(4) (all with dividends reinvested) | 31 March 2023 | 31 March 2022 |
| Net asset value(1) (NAV) – debt at fair value | +7.9% | +14.1% |
| Share price(2) | +8.4% | +10.6% |
| FTSE All-Share Index(2) | +2.9% | +13.0% |
The Company’s benchmark is the FTSE All-Share Index.
| Capital Return(1)(4) | At 31 March 2023 | At 31 March 2022 | Change % | |
| Net asset value – debt at fair value | 713.75p | 686.69p | +3.9 | |
| Share price(2) | 660.00p | 634.00p | +4.1 | |
| FTSE All-Share Index(2) | 4,157.88 | 4,187.78 | -0.7 | |
| Discount(1)(3)(4) – debt at fair value | (7.5)% | (7.7)% | ||
| Gearing (debt at fair value)(1)(3)(4) | – gross gearing | 6.6% | 10.3% | |
| – net gearing | 4.7% | 4.4% |
| Year Ended | Year Ended | ||||
| Revenue and Dividends(3) | 31 March 2023 | 31 March 2022 | Change % | ||
| Revenue return per ordinary share | 25.99p | 22.41p | +15.6 | ||
| Dividends | – first interim | 6.40p | 6.00p | ||
| – second interim | 6.40p | 6.00p | |||
| – third interim | 6.70p | 6.40p | |||
| – proposed final | 6.70p | 6.40p | |||
| – total dividends | 26.20p | 24.80p | +5.6 | ||
| Consumer Price Index(2)(4) – annual change | 10.2% | 7.0% | |||
| Dividend Yield(1)(3)(4) | 4.0% | 3.9% | |||
| Ongoing Charges Ratio(1)(3)(4) | 0.53% | 0.52% | |||
Notes:
(1) These terms are defined in the Glossary of Terms and Alternative Performance Measures, including reconciliations, on pages 83 to 86. NAV with debt at fair value is widely used by the investment company sector for the reporting of performance, premium or discount, gearing and ongoing charges.
(2) Source: Refinitiv.
(3) Key Performance Indicator.
(4) Alternative Performance Measures.
References to page numbers in the Annual Financial Report, which will be available from the Company’s website: www.edinburgh-investment-trust.co.uk
Chair’s Statement
DEAR SHAREHOLDER
It has been a great pleasure to lead your Company in my first year as the Chair of the Board. Together with my fellow Directors, and the Company’s Manager, we have continued to build on the strengthening investment track record to position the Company as a core holding for long-term savers.
I would particularly like to thank my predecessor, Glen Suarez, who stood down as planned at last year’s Annual General Meeting after nine years on the Board. In recent years he oversaw a transition of the Company with a new Manager and supporting team, a sustainable and rising dividend, very attractively priced long-term debt financing and the initiation of a new marketing strategy, which has been further refined in the past year. This is an excellent position from which the rest of the Board and I look forward to building further.
PERFORMANCE
It has been another encouraging twelve months for the Company’s investment returns. Growth in both the Net Asset Value (NAV) and the share price comfortably exceeded the benchmark index, the FTSE All-Share Index. The NAV return was 7.9% against the index return of 2.9%. These are in total return terms (i.e. the combination of capital appreciation plus income received). We are therefore building a track record under the new Manager that meets the Company’s first investment objective – a long-term increase of the NAV per share in excess of the index.
The Company’s share price total return was 8.4% over the year: the share price itself moved from 634p to 660p, a rise of 4.1%, with the balance coming from the dividends paid to shareholders. The share price return differs from the NAV return because of the changing share price discount to NAV. For this year the discount narrowed marginally from 7.7% to 7.5%.
There are a number of investment factors that have influenced the Company’s returns over the year. Most important are the performance of the businesses held in the Company’s portfolio. Your Manager takes mainly a ‘bottom-up’ approach, seeking to construct a diversified portfolio. Echoing this, some of the major drivers of returns over the year included the holdings in BAE Systems, NatWest, Centrica and Greggs. To a lesser extent there were offsetting negative returns from some of the mining stocks held, including Anglo American and Newmont. Other factors that contributed to the overall return were:
â— UK equities continue to rebound, outperforming global equities. After an extended period of dull returns for UK equities, extending to before the Brexit referendum of 2016, a combination of strong fundamentals and attractive starting valuations have come to the fore;
â— The positive returns have been despite the challenging geopolitical situation, including the war between Russia and Ukraine;
â— Another headwind for elements of the equity market has been inflation. Here in the UK there is hope that this might start to recede and that the cost of living crisis might in turn abate;
â— The UK equity market appears to have taken the recent concerns about some banks in the US and Switzerland in its stride. The Manager is alert to how this may affect bank lending appetites, including in the UK, which could in turn impact the economic outlook;
â— The effect of marking the Company’s new loan notes to fair value, reflecting the fall in value of the debt that the Company issued in 2021/2 due to the rise in government bonds yields. As I wrote in the interim report, this boosted the NAV by c.4% during the year and is explained in more detail below.
It is also important to consider longer term returns: it has now been three years since the change of Manager to James de Uphaugh and his team. It is gratifying to see that the Company’s growth in NAV has exceeded that of the FTSE All-Share Index in each of the three successive 12-month periods. Taken as a whole, over the three years to 31 March 2023, the Company’s cumulative NAV total return has been 65.9%, with the Company’s benchmark index returning 47.4% over the same period. Over the past five years, the Company’s NAV return has been 25.2% cumulatively, compared with the Company’s benchmark index returning 27.9% over the same period. In all these cases, the NAV is stated after deducting debt at fair values.
In our view, three years is the minimum period over which investment success can be properly assessed. It is clearly positive that the Company has had such encouraging returns over this period. Growth in the share price has been more volatile, outperforming the index in two of these three years. Further, the discount has narrowed from 11.5% in March 2020 to 7.5% at the end of March 2023. This results in an overall share price return (which is ultimately what shareholders experience – as distinct from the NAV) of 75.5%, which exceeds the NAV return. I will come back to the approach we have taken towards the discount below.
ENVIRONMENTAL, SOCIAL AND GOVERNANCE INVESTMENT FACTORS
We believe an important component of profitable investment decisions is the consideration of Environmental, Social and Governance (ESG) factors. Well managed and governed companies tend to make successful long-term investments. The Manager therefore considers such issues as an integral part of their research and investment process. The Manager’s report describes this in more detail, as does the summary of the Manager’s voting activities in respect of each investee company. This is the first time that we have included the detail of how we have exercised the Company’s voting rights as a shareholder. You will also see that we have included some examples of the engagement the Manager had with investee companies on some of the more contentious issues. I encourage you to read these interesting examples.
DIVIDS
We have announced three interim dividends so far this year, totalling 19.5 pence per share. For the final dividend, the Board is proposing a payment of 6.7p per share, taking the total to 26.2p per share. This final figure is a 5.6% increase on last year. When divided by the year end share price of 660p, it results in a dividend yield of 4.0%. This compares with the dividend yield on the FTSE All-Share Index of 3.5% on average.
The dividend increase of 5.6% is behind the level of UK inflation over the same period. As is evident from the bar chart of longer-term dividend growth rates on page 4, we are not currently meeting the second of the Company’s two objectives: to grow dividends per share in excess of UK inflation. We used these reserves to maintain the dividend initially, but it became apparent that the natural level of income generated by the portfolio was not going to be sufficient, in the long run, to maintain the dividend and, after much deliberation, decided to reduce it in the financial year to March 2021. Looking forward, with expectations for inflation coming down and noting our confidence in the ability of our portfolio companies to grow their distributions, we anticipate a return to the dividend rising above normalised inflation.
For this last financial year, I am pleased to report that dividends received by the portfolio have continued to rise and in conjunction with our lower costs of debt the P&L is in better shape. This means that the dividends in respect of this financial year are almost entirely covered by earnings: as the table on page 2 shows, dividends for the year of 26.2p compare with revenues of 26.0p.
Another important feature to note is that many of the stocks held in the Company’s portfolio are buying back their own shares for cancellation. The Manager explores this in more detail in his report later in this document but suffice to say, share buybacks are another form of redistribution to shareholders, but in the form of capital rather than income. Sometimes these buybacks complement dividends paid to shareholders, other times they replace them. Either way, the returns to shareholders of capital or income support the broader concept of total returns which I used when reporting performance at the beginning of this statement.
BORROWINGS
An element of borrowings, sensibly managed, should enhance long-term returns to shareholders. For investment companies this requires the returns from the equity portfolio to exceed the cost of the debt.
This year has marked a major change in the borrowing costs of the Company. The last of the Company’s debentures, a £100m issue dating back to 1997 and costing 7.75% per annum, matured last September. The debt that has replaced it costs an average of 2.44%: an immediate interest saving of over £5m a year. You may ask how such an attractive rate of interest has been achieved, given the much higher interest rates that have become prevalent of late. The answer is that the Company contracted this interest rate with its lenders in September 2021, a year in advance of the debenture maturing. With hindsight, this proved extremely fortuitous timing.
To reiterate an earlier point, the fall in government bond prices (and rise in their yields) has contributed to a reduction in the fair value of the outstanding loans. This does not affect the balance sheet presented later in this report, where loans are stated at par. But this does effect the level of reported gearing (and investment returns) for which our long-standing practice – and that of the Investment Trust sector generally – is to deduct loans at fair value. Gearing calculations on this basis are set out in full in the Glossary on page 84. Net gearing was 4.7% at the year end.
The Board monitors the level of gearing against various conservative thresholds. The stated policy is that it should not exceed 25%. The current level of gearing is therefore significantly below this threshold. But, in the event of unhelpful market moves that drive up the level of gearing, the portfolio is highly liquid. None of the NAV is attributed to unlisted, unquoted, or private investments, and we have no plans to go down that route.
Overall, the borrowings have positively enhanced shareholder returns in the last financial year – this is quantified in the table on page 15 – and we are optimistic that this should also apply over the next three years and beyond.
SHARE PRICE DISCOUNT TO NET ASSET VALUE
The discount varied from a low of 12.0% to a high of 4.8%. It finished the year at 7.5%. We consider this an acceptable performance as discounts across the investment trust universe as a whole have generally widened. But we are not complacent. We would like to see the discount narrow further as more investors are attracted to the Company as a reliable long-term savings vehicle. The marketing initiatives I describe below are designed to help narrow the discount.
While the discount is at current levels, we will continue with our policy of periodic share buy backs. Over the year we have bought back 3% of the Company’s shares which we have retained in Treasury. These buybacks modestly enhance net asset value for shareholders (see table on page 15) and we are continuing with our policy of actively buying back shares while the discount persists. A further 655,000 (0.33% of the issued share capital) of the Company’s shares have been repurchased since the end of the financial year.
MARKETING
As mentioned earlier we have embarked on a range of new or enhanced promotional activities. You may have seen our new website, press advertisements, or noticed our greater digital promotion through avenues such as Twitter and LinkedIn. The clear intention here is to raise the profile of the Company and generate increased buying of shares, whether from new or existing shareholders. The Board is monitoring a series of Key Performance Indicators to assess the effectiveness of this promotional spend and would encourage you to sign up on our website to receive monthly updates.
BOARD AND GOVERNANCE
At this year’s Annual General Meeting, Vicky Hastings will not be standing for re-election. The board has been very fortunate to have had Vicky’s wise counsel and exceptional attention to detail for ten years. The last twelve months were an extension to the normal nine years, in order to avoid having the Chair and the Senior Independent Director standing down at the same time last year.
We will all miss Vicky’s hugely valuable insights and her infectious enthusiasm, and we wish her all the very best with her other corporate and charitable board responsibilities. Aidan Lisser has kindly agreed to take on Vicky’s role as Senior Independent Director after the conclusion of the Annual General Meeting in July.
In February we welcomed Annabel Tagoe-Bannerman as a non-executive Director to the Board. She brings particular operational legal and governance experience to the Board. With Annabel’s appointment, it means that we are in the fortunate position of having five directors going forward each bringing different skills and expertise to the boardroom discussions. These are in a range of relevant fields for your Company, including equity portfolio management, marketing, accounting, risk management and regulation. We also have a board that meets or exceeds all the recommended diversity guidelines. I thank all my fellow directors for their hard work on behalf of shareholders over the last year.
ANNUAL GENERAL MEETING
This year’s Annual General Meeting will take place on Wednesday 19 July 2023 at 11.00am at the Balmoral Hotel in Edinburgh. Please note the change of venue from last year. The whole Board and I look forward to meeting as many of you as possible. For those unable to attend in person, the AGM will also be streamed online, with the ability to post questions live into the meeting. The link for electronic access will be displayed prominently on the Company’s website and it will not require a passcode. Please see page 77 for the Notice of AGM for more information.
There will also be a shareholder presentation and update in central London on 27 September. All members of the Board, the Manager and members of his team will attend. Further details will be posted on the Company’s website from next month.
OUTLOOK
As you will see from the Portfolio Manager’s report, there is enthusiasm about the underlying prospects for the stocks in the Company’s portfolio. Set against this is the ever-uncertain economic outlook. The Manager’s approach of maintaining a diversified portfolio is therefore an important feature that should help protect shareholders’ capital over time. Meanwhile, many UK equity market constituents in the portfolio stand at a valuation discount to their international peers. Over time, if these companies deliver the operational results that we believe they can, it seems reasonable to expect this valuation differential to close. Combined with a dividend yield of 4.0%, we believe this leaves the Company well positioned to deliver to shareholders attractive total returns.
ELISABETH STHEEMAN / Chair / 26 May 2023
Portfolio Manager’s Report
For the year ended 31 March 2023
As we review the twelve months to the end of March 2023 and consider what may be ahead for stock markets and economies, it is worth beginning with a reminder of how we manage your Company:
• We manage the Company’s investments by constructing a portfolio of 40-50 stocks. While this is a relatively concentrated portfolio by many standards, we also manage it with the aim of ensuring an adequate level of diversification across industries and economic themes.
• In order to meet the Company’s two investment objectives, we manage the portfolio with a ‘total return’ approach, with ESG factors considered throughout the investment process.
• Most holdings are UK-listed, and we have the flexibility to hold up to 20% in overseas stocks.
• Our aim is to construct a portfolio that has the potential to outperform the UK equity index return over rolling three‑year periods.
• We take the view that returns in excess of the UK equity index should, over the long term, provide a satisfactory return for savers when compared with other equity strategies and asset classes.
• An adequate degree of leverage, appropriately managed, should further enhance long-term shareholder returns.
TOTAL RETURNS OVER THE LAST TWELVE MONTHS
Net Asset Value (NAV) per share rose 7.9%, while the share price rose 8.4%. Both figures exceed the UK equity index return of 2.9%. As the Chair’s statement has described, the NAV’s outperformance of the index came primarily through superior stock selection as well as through the revaluation of the Company’s long-term debt.
In terms of the main stock contributors, the top three were BAE Systems, NatWest and Centrica. These stocks encapsulate the diversified nature of the portfolio, a defence contractor, a UK bank and a domestic energy distribution company. Other contributions came from food-on-the-go retailer Greggs, the international bank Standard Chartered and the mining technology group Weir. The portfolio had exposure to mining stocks and two of the three biggest negatives were Anglo American and Newmont. The third notable negative was from not holding BP for most of the period, as its share price recovered (we bought shares in BP towards the end of the period, as we describe below).
The discount of the shares to NAV narrowed slightly, hence the modestly higher return in the shares than in the NAV.
TRANSACTIONS OVER THE LAST TWELVE MONTHS
We have made fewer than average transactions over the year, with portfolio turnover of 21%. This means the holding period is equivalent to just under five years on average.
The biggest change to the portfolio was the purchase of a holding in BP. The shares were acquired following its latest results, in which the group increased its investment plans in high return energy transition growth engines such as Bioenergy and EV Charging. In addition, it also announced new investment plans in high-return upstream assets, which will help to meet the global requirement for greater energy security post the war in Ukraine. Consequently, the projected medium-term return on investment should improve through to 2030. Capex on energy transition related projects will still represent 45% of mid-term capex. We funded the purchase of BP with a sale of the French energy group Total Energies, which is more exposed to fluctuations in the LNG and gas price.
Other significant purchases included GlaxoSmithKline and its de-merged consumer goods unit, Haleon. Both stand at attractive valuations and should have the additional benefit of refocused management teams. Elsewhere, among the more stable growth stocks in the portfolio, we sold Diageo and Reckitt Benckiser: where we view their share prices as fully capturing their future prospects.
More recently, we have added selectively to our holdings in UK cyclicals with strong market positions such as easyJet, Dunelm, Travis Perkins and Marks & Spencer. The UK economic pulse has been stronger than the consensus expected, with energy bills coming down from the highs of last summer. This takes some pressure off the consumer. These additions to the portfolio were funded by reductions of a number of the more internationally focussed companies such as KPN and Smith & Nephew.
These changes leave the portfolio sensibly diversified, in our view. In addition to diversification by industry and sector, which is evident from the portfolio listing on pages 16 to 17, we also think about the broader drivers of future investment returns. Again, we believe there is suitable diversification that should provide sources of portfolio outperformance, whatever the economic development or condition. These drivers of returns, and the holdings that should benefit, include:
• Supply chain resilience – Tesco, Compass and Intel;
• Capitalising on data analytics technology – WPP, Dunelm & Weir;
• The revenge of the incumbent – NatWest, Marks & Spencer and Centrica;
• Businesses becoming stronger through corporate Darwinism – Whitbread, Serco, RS Group;
• Profitability edge through cost curve positioning – Howdens, Mondi and Anglo American.
ESG CONSIDERATIONS
We take careful account of the ESG considerations of any investment case. Taking account of such things are essential for good investment performance and we do not place any major restrictions on what we can invest in. For this reason, as we note above, stocks like BP and BAE Systems, which might not make it into other investors’ portfolios, are acceptable to us. The acceptability comes with the important caveat that we have to be able to assure ourselves, to the best extent possible, that they are behaving responsibly and making positive change for the future.
To illustrate the kind of interactions we undertake when assessing investments, the team engaged with Dunelm, the British home furnishings retailer, in April and February 2023 and in September 2022:
• During the meeting in April 2023, the team engaged on the group’s proposed remuneration policy ahead of Dunelm’s 2023 AGM. The proposal included a new maximum opportunity for the CEO of 375% of salary (up from 325%) which the team felt was reasonable.
• In a subsequent meeting, the group asked for our input on what we consider to be Dunelm’s most material issues, such as the sourcing of their goods and relationship with suppliers. We also fed back that we appreciate the company’s clear efforts to demonstrate connectivity between the group’s strategy, material issues, and executive pay in its reporting.
• At the meeting in February 2023, the team discussed the group’s near-term earnings and strategy. Dunelm aims to develop product excellence across all price points and effective marketing. It has increased efforts to develop product mastery across more nascent categories where market shares are lower, with the ultimate goal of becoming the one-stop for home spend. The group is also introducing credit to facilitate more spend in bigger‑ticket group sections, like Furniture, which is an area in the market that is growing substantially.
• In September 2022, the team met with Dunelm to discuss how it is controlling costs. The group reported that it was seeing a high percentage of incremental UK homeware spend which could fuel EPS growth through 2023. This engagement work reinforces our view of Dunelm’s business model resiliency. In turn this should support its ability to deliver dividend growth in excess of inflation over the long-term. This is the rationale for it being one of the larger positions in the portfolio.
There are further examples of our ESG engagement with companies on pages 25 to 26.
BORROWINGS
We were pleased to see the successful completion of the Company’s long-term refinancing of its debt last September. The new debt, with an average interest coupon of 2.44% per annum, means a significantly reduced cost of borrowings, leading in practice to a future saving of over £5m per annum compared with the previous arrangements.
We utilise this favourable financing by maintaining a fully invested portfolio. The nature of the borrowings, with an average maturity of 25 years, means that they are essentially permanent in nature. We therefore tend to manage the portfolio with the borrowings fully invested. When the portfolio’s value rises, the gearing should enhance returns, and the converse also applies: when underlying returns are negative, the borrowings make the losses greater. With this in mind, we take a tactical view of the economic and market backdrop and can introduce a cash position to reduce this impact by lowering ‘net’ gearing. For example, we may allow the cash position to build up if we are struggling to find attractively priced investment opportunities and fear the market might be ripe for correction. However, shareholders should think of us as investing the vast majority of the borrowings under normal circumstances. Our gross gearing (borrowings) total would amount to 6.6% as at year end with an offsetting cash balance reducing the net gearing to 4.7%.
DIVIDS RECEIVED
Actual revenue per share for the 12 months to 31 March 2023 was 26.0p. This compares with 22.4p in the previous year – a rise of 15.9%. Clearly this is a very satisfactory outcome. For context, top line portfolio income was £49.0m (+10.8% on 2022), which was split between ordinary dividends of £41.6m (+11.0%) and special dividends of £7.4m (+10.0%). The reason for the revenue per share rise of 15.9% exceeding underlying income growth of 10.8% is that revenues are calculated after deducting costs including debt interest. The new borrowing arrangements, as noted above, have resulted in a significant fall in interest expense.
Looking ahead, we forecast more modest revenue per share growth. Some of this is in part due to a mix effect in the portfolio, with the sale of some higher yielding stocks including Total Energies and Direct Line. Dividend generation nonetheless is robust across the portfolio. Furthermore, the ordinary and special dividends being received understate the shareholder distributions made by investee companies which also include share buybacks. These remain significant: there are ongoing share buybacks by BP, Shell, Unilever and NatWest, plus from many other portfolio holdings. Overall, c40% of portfolio holdings have declared some form of ongoing share buyback. This is supportive of the ‘total return’ ethos that should underpin returns to the Company’s shareholders – whether income or capital growth – in the years ahead.
The Directors’ decision to recommend total dividends for the year of 26.2p mean that dividends are almost entirely covered by revenues for the year: a welcome position to be in.
THREE-YEAR REFLECTIONS
It is now just over three years since we became the Manager of your Company. We took over in the midst of the market sell-off in March 2020, as the full implications of the COVID‑19 pandemic began to dawn.
Since then, our investment approach has helped us deal with an at times rapidly changing economic and market backdrop. The roll-out of COVID‑19 vaccines, the “mini-budget” crisis, rising interest rates, a falling sterling currency and the tech sector sell-off have all had to be navigated. A key advantage throughout this period has been the diversified portfolio.
As it turns out, we became stewards of your portfolio towards the lowest levels of the market. Absolute returns have been strong since then. The end result is, as the Chair has already noted, a cumulative total return of the Company’s Net Asset Value (NAV) per share of 65.9%. The share price, thanks to a narrowing of its discount to NAV, has risen 75.5%. These returns compare with a FTSE All-Share Index return of 47.4%.
In keeping with the stock-driven investment approach, when we analyse the key drivers of returns over the period, we look at the key stock contributors. For the last three years, the big winners also reflect the flexible investment style we take. To illustrate, the top five stock contributors to the outperformance were Ashtead (industrial equipment hire), NatWest (banking), BAE Systems (defence), Centrica (gas utility) and Anglo American (mining). Hence clearly a bias towards a mix of cyclical companies – benefitting from the recovery in the economy over the period compared with expectations at the depths of the pandemic.
Inevitably there have been some less successful decisions along the way. Interestingly, the biggest factor was having little or no exposure to two large commodity groups – BP and Glencore. An important part of the portfolio construction (and risk oversight) process is managing these larger risks. A (very) small number of holdings disappointed in their results, but in each case the holding size had been calibrated to take account of the greater downside risk.
In terms of the income generated over the last three years, revenue per share has been disappointing for shareholders, moving from 27.8p in 2020 to 26.0p in the last financial year. The portfolio was overly dependent on unsustainable dividend income prior to March 2020. We believe it is on a more sustainable and progressive footing now.
Our view is that underlying fundamentals of the portfolio’s holdings ultimately drive the Company’s total returns. We therefore prefer to hold stocks for sufficient time to allow those fundamentals to come through. We have long held the view that this means a three-year period, and this does in fact coincide with the average holding period since we were appointed in 2020.
Overall, we believe the last three years demonstrate the merits of a flexible, long-term total return investment approach.
OUTLOOK
While we are cautious about the outlook for equity markets in general, the better recent returns from UK equities strike us as being the early stages of a recovery in the market. This recovery is rooted in the undervaluation of UK equities that has built up over time for a variety of well-rehearsed reasons such as Brexit and final-salary pension funds reducing equity exposures. Just as these headwinds appear to be waning, we remain optimistic about the specific prospects for the Company’s holdings.
We are cautious about markets because inflation remains a challenge. It will naturally come down to a degree, helped by some inputs such as gas prices being markedly lower than a year ago. But consumer expectations have ratcheted up. Economic history tells us that it is much harder to squeeze inflation back into the bottle, once the inflation genie is out.
At the market level, this economic slowdown is likely to be different from those we have experienced since the turn of the millennium. They may be more reminiscent of those of the 1980s and 1990s: more typical slowdowns when inflation has been too high and interest rates have been raised to choke it off. At the same time, bank lending criteria are likely to tighten in the US because of the recent set of banking failures and near failures in the US and Switzerland, which could present downside risk to economic growth.
On a more positive note, at the corporate level, the current elevated rate of inflation means nominal revenue growth should be tolerable even if real GDP falters. Another help is that China has ‘reopened’. Overall, 2023 could see lower inflation, peaking interest rates and perhaps a slightly better tenor from the consumer.
Therefore, a balanced, diversified portfolio is as important as ever. In market terms, we may have entered a new and different investing environment from that which has prevailed since the financial crisis of 2008. For much of the period since then, it often seemed that an investment style that focused on buying and holding growth stocks – sometimes with little regard to valuation or how durable the growth would be – was all that was required. Now, we have a return to an investment environment in which an understanding of company fundamentals matters, as does an appreciation of how the valuation paid for a stock ultimately determines investment returns.
JAMES DE UPHAUGH / PORTFOLIO MANAGER CHRIS FIELD / DEPUTY PORTFOLIO MANAGER
26 MAY 2023