By Annabel Brodie-Smith
I hope 2018 is off to a good start for you.
It has not been the best start to the year for me as I have been plagued by the lurgy. I am writing this from home, propped up by what seems like a medicine chest of remedies.
On a more positive note, markets are off to a roaring start in 2018 with all-time highs a gogo. A look at my Self-Invested Personal Pension (SIPP) portfolio the other day was just what the doctor ordered!
"Europe was the most favoured region for 2018 in our investment company fund manager poll so it’s relevant that we have Ollie Beckett, manager of TR European Growth to give us his thoughts on European smaller companies"
Annabel Brodie-Smith, AIC
This month we are taking a look forward to 2018 and are fortunate to have the views of two investment company managers. Europe was the most favoured region for 2018 in our investment company fund manager poll so it’s relevant that we have Ollie Beckett, manager of TR European Growth to give us his thoughts on European smaller companies.
TR European Growth was one of the best performing investment companies last year, with the European Smaller Companies sector being one of the best performing sectors.
We also have the opinion of Jeroen Huysinga, manager of JPMorgan Global Growth & Income who also has large positions in Europe, as well as the UK. This company is in the Global Equity Income sector and currently yields 3.6%.
While largely optimistic, Jeroen wisely reminds us, “this environment is not without its risks; higher equity valuations - and the absence of a significant market correction for quite some time - mean investors should guard against excessive risk taking.”
This month our investment expert, Ian Cowie, who writes every week for The Sunday Times, examines why investment companies could help readers in retirement. He explains, “fortunately, investment company shareholders enjoy unique advantages over unit trust and exchange traded fund (ETF) investors when seeking a high, rising and sustainable income.”
Finally, 2018 has seen the arrival of the KID - Key Information Document. This is a European regulatory requirement for investment companies. Before a private investor buys an investment company on a platform they now must prove by ticking a box that they have seen the KID.
In his article, AIC Chief Executive Ian Sayers looks at the significant shortcomings of the KID. These include mandatory performance figures which, in some cases, suggest too favourable a view of likely future performance and a single-figure risk indicator which will potentially be understating the risks.
As Ian emphasises, “I must be one of the few Chief Executives of a trade association who has been inundated by complaints from his members that a regulator is forcing them to overstate their performance and understate their risks!”
Hope you have a healthy month!
Communications Director, AIC
Small is mighty
TR European Growth Trust manager Ollie Beckett on the opportunity of European small-caps
Ollie Beckett, Manager, TR European Growth Trust PLC
Europe became the flavour du jour
As global economies emerged from a searing financial crisis at the turn of the decade, the US and UK seemed to pull ahead of their European cousins. Earnings there lagged; growth tinkered on the edge of deflation; its misaligned cadre of politicians toiled with Grexit and Brexit and much in between.
2017 switched fortunes – Europe became the poster-child for its cousins and the catch-up trade. GDP growth was strong. We believe margins improved with the biggest earnings upgrades in developed markets. Where the US and UK became victim to populism, Europe rejected it.
The strength did not go unnoticed by the European Central Bank (ECB) with President Mario Draghi beginning to prepare the market for a withdrawal of their unprecedented quantitative easing (QE) program, most likely in the latter part of 2018.
"Where the US and UK became victim to populism, Europe rejected it"
Ollie Beckett, TR European Growth Trust PLC
The euro also strengthened to levels last seen before European QE started in spring 2015. It meant larger European companies, whose earnings tend to be harvested from across the globe leaving them at the behest of currency swings, performing less well in 2017. Smaller companies tended to have more of a domestic focus and performed better.
Small is mighty
TR European Growth Trust is a truly small company trust, with a large slice of the portfolio – over 50% – invested in firms under a £1bn market capitalisation. As investors in larger companies in Europe have struggled to find value amid renewed enthusiasm for European shares, they’ve reset their sights further down the scale and targeted mid-sized businesses, which in turn have become more expensive.
We believe it means the smaller end of the market is one of the last remaining places to find relative value, and it’s an area that we have a long history of seeking exciting growth opportunities for our investors.
We’re cognisant of the risks that come with investing in much smaller firms: they are more susceptible to market swings than bigger businesses and can be difficult to trade in large amounts, but to offset this and diversify the risk we run a longer stock list than most funds, at around 140 holdings.
"We believe it means the smaller end of the market is one of the last remaining places to find relative value"
Ollie Beckett, TR European Growth Trust PLC
What to buy
So how do we find the sorts of investments that have the potential for strong capital growth?
We look for businesses with management teams that will continue to take the right decisions to either fix what is broken internally or continue growing their earnings strongly, regardless of geopolitical uncertainties or potential adverse market reactions to more hawkish central banks. It broadly translates into three areas of investment.
‘Value’ is one – companies that we believe the market is pricing below their intrinsic value. The next is growth-at-the-right-price (GARP): firms whose earnings are perceived to be growing more vigorously than their peers or the wider market, but the trajectory of which is being undervalued by the market. The final is turnaround stories or ‘self-help’ as we call it – businesses that have been under-performing and are unloved by the market but striving to change their destinies. Below are some portfolio examples.
Van Lanschot - Dutch banking
Van Lanschot is the oldest independent bank in the Netherlands, dating back to 1737. It’s in the business of private banking, asset management and merchant banking, and in the process of running off a loan portfolio it serves to corporate clients.
Back in April 2016 it presented a new strategy designed to reinvigorate the private banking arm – at the time the division earned around half of VL’s revenues yet accounted for only 7% of total profits, indicating poor efficiency and enormous scope for self-improvement. Looking forward, it is attempting to be more asset-light and build up its capital ratios, returning cash to shareholders wherever possible. As it stands, its return on equity – a measure of profitability – is poor at around 7%; this we believe should be much higher.
The trust has taken a number of positions in Finland as we are finding undervalued businesses there which we think will perform well amid an improving economy.
Alma Media purports as a media owner of regional, local and free circulation newspapers for print and online, and the market is pricing it as such. But what it should be focusing on is what the business is really about: online classifieds - websites that deal in used cars, used equipment and in real estate – of which it is a market leader.
Axel Springer, a similar outfit in Norway, provides guidance in this respect, with the market placing significantly more value on its operations. In our opinion other investors will catch-up with this thinking.
"The trust has taken a number of positions in Finland as we are finding undervalued businesses there which we think will perform well amid an improving economy"
Ollie Beckett, TR European Growth Trust PLC
Growth (at the right price)
Founded in 1993, the group is in the businesses of online drugs, operating a prescription mail order business under its DocMorris brand in Germany, and a market leading online pharmacy business in Switzerland under its Zur Rose brand.
Pharmacy is a market ripe for disruption in Europe: small, relatively high value non-perishable packages are extremely well-suited to e-commerce, which remains a very under-penetrated market considering the 125 thousand bricks and mortar pharmacies across Europe which have operated as such for 500 years.
What is more, the German market has recently been prised open by a European Court of Justice ruling and we believe market leader DocMorris will be a key beneficiary.
Outlook for 2018
"We are still finding stocks that excite us"
Ollie Beckett, TR European Growth Trust PLC
While 2017 was another strong year for European smaller companies we remain cautiously optimistic for the year ahead. European economic growth is at its highest levels for over a decade, much needed inflationary pressures are beginning to build, and European earnings are growing at a higher rate than the US for the first time since 2007. Valuations are elevated versus the past but we do not see excessive levels of optimism from the investment community and we are still finding stocks that excite us. Thus, we continue to look for the best small cap investments in Western Europe.
JPMorgan Global Growth & Income Trust's Jeroen Huysinga discusses why the outlook remains positive
Jeroen Huysinga, Portfolio Manager, JPMorgan Global Growth & Income Trust
2017 was a strong year for equity markets following the age of caution that characterised the post-financial crisis world. This has important implications for earnings globally and the strong returns experienced last year were underpinned by impressive earnings growth.
In fact in Europe, we saw earnings growing for the first time in six years. A point to illustrate the recent resilience of global markets is that 2017 was the first time on record which saw the MSCI World Index (in local currency) generate positive returns in all twelve months of the year.
This backdrop has been much more constructive for our fundamental stock picking approach. While the trust introduced a new dividend policy in 2016 – paying out at least 4% of the net asset value set at the start of each financial year – it is important to note that there were no changes made to the underlying investment process.
We continue to have the freedom to invest anywhere in the world in the best ideas from across our team of seventy in house research analysts. We look to build a portfolio of high conviction stocks which offer an attractive valuation signal, demonstrate profit growth potential, possess an identifiable catalyst and satisfy a timeline horizon.
Our focus is on the long-term cashflow and earnings potential of companies and we draw on a common framework which allows us to compare our valuation insights across global sectors in a consistent manner.
"2017 was the first time on record which saw the MSCI World Index (in local currency) generate positive returns in all twelve months of the year"
Jeroen Huysinga, JPMorgan Global Growth & Income Trust
Opportunities in retail
Today this approach leads us to find interesting investment opportunities in a number of industries around the world, for example in retail, perhaps somewhat controversially in the wake of perceived industry damage inflicted by Amazon.
Short-term weakness in the retail sector has provided opportunities to buy the likes of O’Reilly because despite Amazon moving into the auto parts business, O’Reilly has some very significant advantages that will make it very tough for Amazon to make rapid progress in the categories that matter to them.
O’Reilly has undervalued advantages in terms of the efficiency and breadth of their distribution system, the depth of their inventory and the reassuring presence of a high-touch high-service person behind a counter.
Regionally our bottom-up process continues to result in large positions in Europe and the UK whereas North America is an area in which we are underweight. In the latter region, excessive valuation still prevents us from investing in bond equivalents and many other mega caps.
Furthermore, being a global investor allows us to look past where a company happens to be listed and focus on the underlying business and drivers of earnings. In the UK, for example, many of the companies we own are international businesses that happen to be listed in the UK.
"The environment remains very positive for equity investing, particularly outside the US, where valuations seem a lot more reasonable"
Jeroen Huysinga, JPMorgan Global Growth & Income Trust
Outlook for 2018
Looking to the rest of 2018, the environment remains very positive for equity investing, particularly outside the US, where valuations seem a lot more reasonable and high operational leverage, particularly in Europe and Japan, will see companies benefit from better nominal growth.
In the US, the economy has entered the later stages of the economic cycle given the economy is now close to full employment, but the risk of an imminent recession appears low and forecasts of continued earnings growth in 2018 look to be very much on course.
With stock correlations at low levels, this presents attractive opportunities for bottom up stock pickers. We expect this backdrop to continue with a continued, synchronised global recovery in earnings. Investors should expect this to reinforce the economic cycle as companies become more willing to invest in capital expenditure and labour, especially in the US and Japan where reform packages aim to encourage this.
However, this environment is not without its risks; higher equity valuations—and the absence of a significant market correction for quite some time—mean investors should guard against excessive risk taking.
A rising, sustainable income
Ian Cowie explains how investment companies could help
Retirement really should be the holiday of a lifetime. But, even more than is the case with a short summer break, you need sufficient money to make the most of it.
Unfortunately, today’s low interest rates mean large sums of capital are required to produce relatively modest amounts of income.
Fortunately, investment company shareholders enjoy unique advantages over unit trust and exchange traded fund (ETF) investors when seeking a high, rising and sustainable income. Technical but important differences between these three types of pooled funds have helped 21 investment companies to increase income payouts to shareholders every year for more than two decades. Even more impressively, four investment companies have done so for more than 50 years.
The ‘Fab Four’ among these investment company dividend heroes are Alliance Trust, Bankers Investment Trust, Caledonia Investments and City of London Investment Trust. Each has increased dividend distributions every year since 1967. That was when Sandie Shaw won the Eurovision Song Contest with ‘Puppet on a String’ and Prime Minister Harold Wilson announced Britain aimed to join what was then the European Economic Community and is now the European Union.
"Investment company shareholders enjoy unique advantages over unit trust and exchange traded fund (ETF) investors when seeking a high, rising and sustainable income"
How did so many investment companies manage to increase income payments to shareholders during decades that saw the bursting of the dot com bubble at the turn of the century, the global credit crisis and interest payments to bank and building society savers plunging to historic lows?
First, investment companies have a unique ability to smooth out some of the shocks of the stock market by retaining up to 15% of dividends in good years to top-up payouts in bad years.
Second, they may supplement dividends with capital gains from their underlying portfolio of assets – a feature introduced six years ago. Neither of these financial shock absorbers is available to people aiming to fund retirement with income from unit trusts, open-ended investment companies (OEICs) or ETFs.
Both could be vital advantages for pensioners if setbacks of any description cause global stock markets to fall from their current all-time highs and lead to dividends being cut or cancelled.
Pensioners are potentially very vulnerable investors because, by definition, they are unlikely to have much earned income.
Nor are they likely to be able to put in a bit of overtime to make good the damage done if the stock market plunges by nearly 50% - as it has done twice this century so far.
Of course, the past is not necessarily a guide to the future. But it does provide one factual basis upon which to make forecasts about what might happen in the years ahead.
This raises a third advantage that investment company shareholders - including your humble correspondent - enjoy over most ETFs and many passive unit trusts and OEICs or tracker funds. Most investment companies are actively managed which means professional analysts aim to use stock selection to avoid over-priced shares which have already soared into the indices and to identify bargains which may deliver the best returns in future.
By contrast, tracker funds passively follow indices, most of which are based on stock market capitalisation - or the total value of each company’s shares. So inclusion in most indices is reliant on past performance, which might not continue in the future, and could also cause investors in passive funds to inadvertently follow financial fashion, buying expensive shares and shunning bargains.
"While high yields can sometimes prove to be warnings of trouble to come, active stock selection may also help to identify companies that will deliver rising streams of income in future"
That distinction is particularly important for income-seeking investors because out-of-favour shares are most likely to offer higher yields - or the dividends paid to shareholders, expressed as a percentage of the share price.
While high yields can sometimes prove to be warnings of trouble to come, active stock selection may also help to identify companies that will deliver rising streams of income in future.
Helpfully, the AIC’s website shows how each investment company has managed to increase dividend distributions in the past. Across all investment companies that are AIC members, the average annual increase in income payments to investors over the last five years is 3.1%.
This happens to precisely match the current annual rate of inflation, as measured by the Consumer Prices Index (CPI), and shows how most investment companies are succeeding in preserving the real value or purchasing power of their shareholders’ income.
While there is no guarantee this will be sustained - because share prices may fall and you might get back less than you invest in the stock market - investment companies’ unique structural advantages over other pooled funds may continue to prove important considerations for investors seeking a high, rising and sustainable income.
Ian Cowie is a columnist at The Sunday Times
KIDs, eh? Who’d have ‘em?
AIC Chief Executive Ian Sayers explores Key Information Documents
After Christmas, we should not need reminding that the best of intentions can sometimes turn out very differently to what we expect.
Sending cards, buying presents, visiting family and friends for food or drink – all seem harmless enough at the beginning of December. But unless you are meticulous in your planning, I expect many of us reach the end of the holidays wondering how everything suddenly got out of control. That, and of course checking the calendar for when the kids will be returning to school.
In some ways, directors of investment companies probably feel much the same about their own KIDs (which in this case refers to Key Information Documents). When these were proposed about five years ago, it would have been hard to argue against the idea of having a standard document which presents comparable information on what you will be investing in, performance, risk and costs.
Fast forward to today, and things don’t seem quite so clear. Firstly, the gestation period for these rules has coincided with a strong and consistent bull market. This means that the mandatory performance figures will, in some cases, be suggesting too favourable a view of likely future performance. Secondly, the single-figure risk indicator will potentially be understating the risks.
"I must be one of the few Chief Executives of a trade association who has been inundated by complaints from his members that a regulator is forcing them to overstate their performance and understate their risks"
Ian Sayers, AIC
I must be one of the few Chief Executives of a trade association who has been inundated by complaints from his members that a regulator is forcing them to overstate their performance and understate their risks! But it is one of the happy features of the investment company sector that independent directors are more interested in presenting a fair picture than simply complying with rules. Unfortunately, there is little that members can do, as the rules are prescriptive and do not allow for much individual judgement to be exercised.
Another worrying issue is that UCITS funds will not be required to provide a KID on this basis for another two years. They will still be producing a KID (as they have done for some years) but this will differ in terms of how it presents performance, risks and costs. As KIDs are meant to be about comparability, this decision defies explanation.
To give just one example, an investment company KID issued this year will include underlying transaction costs. I know many commentators who have been pushing for the inclusion of transaction costs and will no doubt support this. However, the equivalent UCITS KID will not include these costs.
"In their respective KIDs, the investment company costs will look higher, as UCITS can continue to exclude transaction costs"
Ian Sayers, AIC
One of the advantages of the closed-ended structure is that fund managers do not have to trade the portfolio when people buy and sell investment company shares, as opposed to an open-ended fund manager who has to buy/sell investments as investors move in/out of the fund. So, all things being equal, the investment company’s transaction costs should be lower. Yet, in their respective KIDs, the investment company costs will look higher, as UCITS can continue to exclude transaction costs.
Though there is little we can do about this unsatisfactory situation, we have asked the Financial Conduct Authority to help inform consumers about the significant differences between these two types of KID. But experience shows that consumers are unlikely to appreciate these differences and, as these two very different documents are called the same thing, consumers are likely to assume they are calculated on the same basis and therefore comparable. And you can hardly blame them.
Hopefully, of course, investors will take a broader view, and use all the information available to them to make an informed choice. After all, at this time of year, we should all remember that, where KIDs are concerned, rushed purchases can easily lead to disappointment.