Foreword
By Annabel Brodie-Smith
Despite the first half of the year’s continued political uncertainty with a shock election, the surprising result of a hung parliament and the triggering of Article 50, investor confidence in the stock market has remained strong in 2017. The FTSE 100 Index started the year at 7,178 and closed at the end of June at 7,313, providing a total return of 4.7%.
The investment company sector has generally performed well in the first six months, with the average company returning 10%. The European sectors performed particularly well and this was partly due to the fall in sterling after the Brexit vote. To find out more about the top performing sectors in the first half of 2017 see our release.
Sterling again features in the article written by the “contrarian to the core,” Alasdair McKinnon, manager of The Scottish Investment Trust in his article on how the trust can take advantage of Brexit's unexpected opportunities.
"We're contrarians to the core"
– Alasdair McKinnon, Scottish Investment Trust
Alasdair explains how the weakening of the pound after the Brexit vote has boosted the value of this global investment company’s investments and enhanced their dividend income, allowing them to pay a special dividend and increase the dividend by 40% this year. He also fully explains their investment approach including the ‘ugly ducklings’, the unloved shares which hopefully will surprise positively.
Two weeks ago, the FCA issued the results of their study into competition in the asset management sector. You may well have read the considerable press coverage on this report but frustratingly it focussed almost exclusively on open-ended funds (unit trusts and OEICs) and failed to properly consider investment companies.
Ian Sayers, Chief Executive of the AIC explains why this is a missed opportunity to create real competition in his blog. Investment companies offer so many of the features that the FCA sees as beneficial. Investment companies have delivered strong long-term performance for investors, regularly outperforming their benchmarks over time. They have independent boards of directors who owe their duties first and foremost to shareholders and can introduce reduced fees as the fund grows.
Finally, we would very much appreciate it if any enthusiastic investors could volunteer to share their investment company experiences with the media. Please complete the form and we will be in touch with you if there is a media opportunity. Those who are published will receive a bottle of champagne and we will donate £100 to the charity of your choice.
I’d like to wish you a wonderful and relaxing summer. Compass is taking a holiday in August but we will be back in September.
Annabel Brodie-Smith
Communications Director, AIC
Investment company performance
Which have been the highest-returning sectors in the first half of this year?
It’s been an interesting start to 2017. Article 50 was triggered, UK inflation reached a four-year high but investor confidence in the stock market has remained strong, with the FTSE 100 Index starting the year at 7,177.89 and closing at 7,312.72 at the end of June, providing a total return of 4.7%.
The investment company sector has generally performed well in the first half of the year, with the average company returning 10%. Which have been the best performing investment company sectors in H1?
Europe
Over the six months to the end of June 2017, the best performing investment company sector by some margin is European Smaller Companies, up 32% on a share price total return basis.
Undoubtedly the fall in sterling had a positive impact on overseas investment, with Europe having had a strong first six months generally. The Europe sector is up 22% and the Property Direct – Europe sector up 19%, putting them in third and fifth place respectively.
"The best performing investment company sector by some margin is European Smaller Companies"
– AIC
Smaller Companies
Smaller companies in general have seen particularly strong performance for the first half of 2017, with the Japanese Smaller Companies sector the second best performing sector overall, up 23%, and the UK Smaller Companies sector up 17%, putting it in sixth place.
"Smaller companies in general have seen particularly strong performance for the first half of 2017"
– AIC
Asia Pacific
Interestingly, the Asia Pacific sectors have also had a good start to the year with Country Specialists: Asia Pacific returning 20% and the Asia Pacific excluding Japan sector returning 16%. The Japan sector completes the list of top 10 best performing sectors, with a share price total return of 14% over the half-year to the end of June 2017.
Commenting on the best performers of the year so far, Annabel Brodie-Smith, Communications Director, Association of Investment Companies said:
“The fall in the value of sterling since the Brexit vote, together with positive European election results, has contributed to the strong performance of the European investment company sectors.
"Nonetheless, the 32% share price total return from the European Smaller Companies sector over the six months to the end of June is an impressive achievement.
"Investment companies generally perform well in strong markets and the first half of the year reflects this, with the average company up 10% and the average discount narrowing from 3.8% to 1.7%.
"The average investment company is up 10% and the average discount has narrowed from 3.8% to 1.7%"
– Annabel Brodie-Smith, AIC
"Of course, it’s interesting to look at the top performing sectors but there’s no guarantee that this performance will be repeated. Investors need to invest for the long term, hold a balanced portfolio and must do their research on potential investments bearing in mind their financial needs.
"If investors have any doubts over investing they should talk to a financial adviser.”
The top 10 best performing investment company sectors by % share price total return over the six months to 30 June 2017. Source: AIC using Morningstar.
Unexpected Brexit opportunities
Alasdair McKinnon, Manager of The Scottish Investment Trust, explains why the surprises of the past year have been a gift for 'ugly duckling' investors
Alasdair McKinnon, Manager, Scottish Investment Trust
At The Scottish, we’re contrarians to the core. So we aren’t dismayed when events don’t go as widely anticipated. After all, the prevailing expectation is the consensus view – and that’s exactly what we aim to avoid.
Last year’s Brexit vote is a good example. The outcome may have been unexpected, but it wasn’t a scenario we had ruled out. We always try to consider the potential impact of significant events, even when consensus tells us that they’re unlikely. Above all, our contrarian investment style is designed to benefit from change. Sometimes, those changes can be triggered by unexpected events.
This proved to be the case with the Brexit vote. One of its effects was to weaken the pound. As a global investment trust, we have most of our investments overseas. Sterling’s devaluation boosted the value of these investments when translated into pounds, to the benefit of our shareholders.
"We're contrarians to the core"
– Alasdair McKinnon, Scottish Investment Trust
Meanwhile, our exposure to out-of-favour UK large caps proved beneficial. As most of their revenue is generated abroad, sterling’s weakness boosted their earnings and share prices. It also enhanced the dividend income we receive.
This extra revenue enabled us to pay a special dividend this year – which resulted in a 40% increase in our total dividend.
Going against the grain
Our contrarian approach is grounded in the observation that people like to belong to a group. We believe this crowding instinct can work against the best interests of investors. Accordingly, we don’t attempt to follow investment fashions. Instead, we seek out investments in which we can foresee long-term upside.
In doing this, we think that it’s crucial to ignore the emotions associated with past performance and to view each investment on its future merit.
Taking this contrarian stance requires lateral thinking and a willingness to ignore the prevailing views of other investors and companies themselves. This is because both markets and company management teams have a propensity for hubris in the good times and unjustified pessimism when times are hard. Standing apart from the crowd is often uncomfortable, but we are prepared to be patient.
The three categories of opportunities
We see three categories of opportunity. First, we have ‘ugly ducklings’ – unloved shares that most investors shun. These companies have endured extended periods of poor operating performance, and their near-term outlook can appear uninspiring.
But we view their out-of-favour status as an opportunity and can foresee the circumstances in which they can surprise positively. Such companies often have a higher-than-average yield, providing an attractive income while we wait for our investment thesis to unfold.
Our second category consists of companies where ‘change is afoot’. These companies have seen a significant improvement in their prospects, which have not yet been recognised by the market. Often, they are disliked for historical reasons, with investors unwilling to credit signs of change.
Thirdly, we have stocks where we see ‘more to come’. Unlike the first two categories, these companies are generally recognised as good businesses, but we believe that the market does not fully appreciate the scope for further improvement.
Finding opportunities in pessimism
So where are we finding these opportunities? The Brexit vote established a strong negative consensus on certain sectors of the market, with one such area being the UK retail sector. The high street is facing challenges from online shopping as well as the perceived threat to the UK consumer from the decision to leave the EU. This has generated significant pessimism – and where there is pessimism there are often contrarian opportunities.
"Where there is pessimism there are often contrarian opportunities"
– Alasdair McKinnon, Scottish Investment Trust
Marks & Spencer is an example that falls into our ‘ugly duckling’ category. Its shares were already unloved but fell further after the Brexit vote. However, the company has a new, experienced and credible leadership team, which is implementing meaningful change.
"By focusing on the overlooked and out of favour, we are confident change can be an opportunity"
– Alasdair McKinnon, Scottish Investment Trust
The company’s strong brand and popular food offering should stand it in good stead as it implements simple but important changes to operations and products. And while we wait for these improvements to come through, the shares provide a strong, sustainable dividend.
We can’t control unexpected events. But we can avoid the crowded trades that are easily upset. By focusing on the overlooked and out of favour, we are confident change can be an opportunity.
Flat whites and consumer rights
How the FCA's Asset Management Market Study could have brought real competition to the sector
Ian Sayers, Chief Executive, AIC
Do you remember the day the ‘flat white’ first emerged on the High Street? No, nor do I.
But I do recall wandering into one of the major coffee houses a week or so after one of their competitors had introduced it to see what could only be described as a glorified post-it note with the words ‘We sell flat whites’ handwritten on it. Within a few weeks, this had been replaced by a new menu board. A few months later, I doubt there was a coffee house in the land that didn’t offer a flat white.
How competition should work
This is how competition should work. A company enters a market with something the consumer wants and sees its business benefit. Just as importantly, competitors watch each other like hawks, and if they see one grabbing market share, they respond by improving their customer offering.
Unfortunately, this aspect of competition seems to have bypassed the FCA’s thinking in its asset management market study.
Disclosure and independent governance
The FCA basically offers two immediate solutions to improve consumer outcomes. The first is disclosure. Now, no-one can argue that consumers should not be properly informed about their investment. But the blunt fact remains that most consumers don’t use the information they have at present. This is not to argue against reform, but simply to acknowledge its limitations.
The other is independent governance, the idea of appointing independent directors to Authorised Fund Managers with a specific duty to consider the value-for-money proposition.
"Unpalatable as it may sound to consumers, directors of asset management firms cannot always put customer interests first"
– Ian Sayers, AIC
Personally, I think the FCA has underestimated the difficulties here. Unpalatable as it may sound to consumers, directors of asset management firms cannot always put customer interests first. Directors of companies owe their duties, first and foremost, to the shareholders of the company, not their customers. UK company law (rightly) has some tough rules requiring directors to avoid placing themselves in a position of a conflict of interest. Quite how these new directors of Authorised Fund Managers will reconcile their duties to shareholders, and these duties to consumers, remains to be seen.
The strong case for investment companies
Of course, for investment companies, these issues do not arise. Their shareholders and their customers are one and the same, and the Board can place their interests first without any of these inherent conflicts. So, they can negotiate reduced fee rates as the fund grows which, as the FCA notes, is so conspicuously absent in the open-ended world. They also outperform their benchmarks far more regularly over the medium and long-term, another area of concern for the FCA.
So what was the FCA’s response on investment companies, which embody the independent governance it would like to see elsewhere and deliver better returns for investors. Simply to suggest that any new rules for open-ended funds might also be introduced for investment companies. Hardly an incentive for others, is it?
"What we need is to make sure that funds that offer something better for consumers benefit from increased demand"
– Ian Sayers, AIC
The adviser market
Rather like the flat white, what we need is to make sure that funds that offer something better for consumers benefit from increased demand. We have argued that the FCA should look again at the adviser market. Since RDR, we have seen purchases of investment companies via platforms nearly quadruple to close to £800m a year, but they still account for less than 1% of all purchases made by advisers (currently running at more than £100bn a year).
Advisers’ reluctance to recommend investment companies often stem from concerns or misunderstandings over their regulatory duties rather than what will deliver the best long-term outcomes for their clients. In many cases, what is required is not a change to the rulebook but simple clarity over what the FCA expects of advisers.
So we will continue to press the case, and hope to speak with the FCA soon about how investment companies could drive competition in the funds sector in the consumer interest.
Maybe, in fact, over a cup of coffee.
