Spotlight - September 2018
How was your summer? Mine was an opportunity to switch off as many screens as possible, read some books, take a few walks and, I have to admit, eat and drink a little more than I probably do in the average week.
But fortunately for investors in the tech sector, not everyone shares my simple tastes. Catharine Flood, client services director at Scottish Mortgage is undoubtedly correct when she talks about a “paradigm shift in the global economy to a ubiquitously mobile, digitally interconnected world.” This month, we hear from Scottish Mortgage, Bankers, Brunner and Mid Wynd International about the opportunities in technology companies and why they believe investors cannot afford to miss out, despite valuations that appear high by conventional metrics.
While I was ambling over the Wiltshire and Oxfordshire countryside, Alasdair McKinnon, manager of the Scottish Investment Trust, was sampling the more sophisticated pleasures of New York.
He writes a thought-provoking piece about whether the “American empire” is showing “signs of decadence”, and argues that “investors’ indiscriminate appetite for technology and for growth at all costs might need to be drastically reappraised as the era of cheap money comes to an end”. (Never let it be said we don’t bring you contrasting viewpoints in Spotlight.)
Over the next few days, I’ll swap my walking boots for my wheelie case as we get ready for the autumn training season. We are visiting Edinburgh, Guildford, Knutsford and Birmingham with some very interesting portfolio managers, and will be looking at the ways in which investment companies are adapting to the needs of today’s investors.
There is still time to book for any of these seminars. Dates and times are below, and we hope to see you there.
All the best for a productive and successful autumn.
Nick Britton, Head of Training, AIC
Upcoming events across the UK
AIC Seminar (Edinburgh)
9:30 – 12:30. Speakers: Hamish Baillie (Ruffer Investment Company), Matt Brett (BG Japan Trust), Paul Niven (F&C Investment Trust), Nick Britton (AIC).
AIC Seminar (Guildford)
9:30 – 12:30. Speakers: James Hart (Witan Investment Trust), Sebastian Lyon (Personal Assets Trust), Jon Forster (Impax Environmental Markets), Nick Britton (AIC).
AIC Seminar (Cheshire)
11:30 – 2:30. Speakers: Alex Crooke (Bankers Investment Trust), Judith McKenzie (Downing Strategic Micro-Cap Trust), Ross Teverson (Jupiter Emerging & Frontier Income), Nick Britton (AIC).
AIC Seminar (Birmingham)
9:30 – 12:30. Speakers: Sam Cosh (European Assets Trust), Ben Rogoff (Polar Capital Technology Trust), Steve Tatters (Aurora Investment Trust), Nick Britton (AIC).
Some of the fund managers speaking at our autumn seminars
Technology: the summit or the start?
Investment companies comment on the technology sector's opportunities and outlook
Last month Apple became the first public company in history to reach a market capitalisation of $1 trillion. Apple’s growth from a share price of $1 in 1999 to $225 in 2018 is symbolic of the rapid expansion of technology in the twenty-first century and the strong returns that have been achieved. But with technology companies hitting record highs and making up a growing portion of indices, how are investment companies approaching this theme in their portfolios?
The AIC has collated comments from investment companies investing in technological innovation and disruption including Scottish Mortgage, Bankers, Brunner and Mid Wynd International.
Simon Edelsten, fund manager of Mid Wynd International Investment Trust said: “Investing in technology is key for Mid Wynd as innovation drives growth and keeps companies competitive. We seem to be going through a period of particularly rapid change from developments in the internet and further adaptations of cheap computing power such as artificial intelligence and data processing. These changes challenge many established business models – such as high street retailing – while opening new investment opportunities.”
Catharine Flood, client service director of Scottish Mortgage Investment Trust said: “It is a common misconception that Scottish Mortgage invests in ‘technology’. We don’t. We simply look for any and all companies with sufficient potential to be the standout growth companies of the coming decade. The large platform companies such as Amazon, Google and Facebook in the US and Chinese giants Alibaba, Tencent and Baidu, have created a paradigm shift in the global economy to a ubiquitously mobile, digitally interconnected world. Gene sequencing company Illumina’s technology dovetails with this and is underpinning a global drive towards a personalised genomic-based revolution in healthcare. Tesla is facing the challenge of driving a shift away from fossil fuels.
“We do tend to invest in companies which create or utilise new technologies to develop deep, long-term competitive advantages in addressing large opportunity sets, though we will invest in any business which has this strong asymmetry to their potential long-run returns. Often therefore what we are really doing for Scottish Mortgage is investing in those businesses which are driving progress.”
Alex Crooke, manager of The Bankers Investment Trust said: “As a general rule, we are looking to invest in undervalued companies which have an enduring franchise in a structurally growing end market. The technology sector contains many well-run global leaders which are increasingly taking share from other areas of the economy.”
Where are the opportunities?
Lucy Macdonald, portfolio manager of The Brunner Investment Trust said: “Brunner has a dual objective of real income and capital growth. The broad technology universe offers opportunities for fulfilling both objectives, offering long-term capital growth and some growing dividend yields. IT budgets across the corporate sector are growing strongly, fuelled by robust corporate profits and the urgent threat of disruptive change. End markets favoured for spending, and where we have active exposure, are digital transformation, cloud computing and the Internet of Things. We also favour online travel and digital payments.”
Simon Edelsten, fund manager of Mid Wynd International Investment Trust said: “Our philosophy in Mid Wynd is safety first and if we find, as in Amazon last year, that the share price has moved beyond reasonable forecasts of future cash flows, we sell our holding. In this case we have been shown to be much too early, though our sale of Facebook now looks more prudent.
“Generally, being global investors, we find we can move on to less well known areas of growth and reinvest our profits at more comfortable valuations. Selling some of our FANG holdings came at a time when we could invest in Japanese companies which are global leaders in robotics and automation. These proved fine replacements for our internet investments and continue to convince us they have very strong longer-term growth prospects while trading at very reasonable valuations.”
Catharine Flood, client service director of Scottish Mortgage Investment Trust said: “The initial creative crisis phase has already shifted into a new normal, a digitally interconnected paradigm powered by the data it creates. Those second order companies, such as Twitter, which tried to compete directly only bought incremental changes to the paradigm and their returns have reflected their more limited impact. Of more interest to us are the next generation of companies building their businesses on top of this digital infrastructure. They are addressing specific and large markets such as financial services (Ant International), digital media (Netflix, Spotify), food consumption (Meituan, Delivery Hero and Grub Hub) and transportation (NIO, Full Truck Alliance and Lyft).”
What’s the outlook?
Alex Crooke, manager of The Bankers Investment Trust said: “As long-term focused investors we still believe many of the more powerful secular trends within technology remain underappreciated by the wider market, for example, the disintermediation of bricks and mortar retail stores by e-commerce. Whilst we are all quite familiar with ordering goods online, it is important to note we are still in the early stages of adoption. In the US, e-commerce accounts for just 13% of retail sales and its growth rate has actually been increasing in the last two years. A major beneficiary of this is Amazon, which although it looks expensive on near-term valuation multiples has the potential to substantially grow its profitability in the years ahead as its growth investments naturally begin to subside.
“Another point to mention is the very strong balance sheets many of the more mature technology holdings within our portfolio possess. Apple, Microsoft, Cognizant and Activision Blizzard all boast net cash balance sheets and growing dividends, an attractive combination of resilience and cash distributions for the patient investor.”
Lucy Macdonald, portfolio manager of The Brunner Investment Trust said: “After the strong equity performance we have seen since the financial crisis, there are pockets of overvaluation but in areas of
"We still believe many of the more powerful secular trends within technology remain underappreciated by the wider market"
Alex Crooke, The Bankers Investment Trust
accelerating growth, valuation can remain optically high for extended periods. So what do we avoid? Overvaluation coupled with low quality, decelerating growth or potential obsolescence.”
Catharine Flood, client service director of Scottish Mortgage Investment Trust said: “The scale of the returns from each of these platform businesses so far barely reflects the scope of the changes they have set in motion. They remain at the forefront of progress, with a long way yet to go. The challenge for us is always to think about the potential of what might happen from here as the application of this information technology expands into new industries.
“Though more commonly noted for our optimism, we do have some concerns over the risk of the destructive power of these companies on many of the traditional large incumbents, particularly in the traditional ‘defensive’ sectors. For example, more value was immediately destroyed in aggregate in the businesses disrupted than was created in Amazon and the businesses it acquired, such as WholeFoods, as it broadened the application of its strengths into new areas.
“Many of the established business models in a range of industries have come through previous technological revolutions in the twentieth century unscathed, as these had not touched them directly. The managers of Scottish Mortgage are questioning whether the breadth of today’s paradigm shift might now lead to a greater period of stress.
“Exponential development rates require an ability to embrace uncertainty and change in a way many of the challenged incumbents in a wide range of industries are simply unaccustomed to. The managers of Scottish Mortgage believe in the coming decade returns are likely to go to those businesses best able to embrace progress and invest accordingly.”
Ian Sayers, chief executive of The Association of Investment Companies said: “Whilst it's well known that investment companies in Sector Specialist: Tech Media & Telecomm offer investors access to the technology sector in a targeted way, it's interesting that investment companies in other sectors can provide investors with exposure to technology too. Investment companies' closed-ended structure, active management and ability to spread risk across a variety of countries and companies makes them well suited to harnessing the opportunities of the future.”
"The scale of the returns from each of these platform businesses so far barely reflects the scope of the changes they have set in motion"
Catharine Flood, Scottish Mortgage Investment Trust"
Is the US due a reappraisal?
Alasdair McKinnon, manager of the Scottish Investment Trust, reflects on his recent trip
Alasdair McKinnon, Manager, The Scottish Investment Trust
"If I'd lived in Roman times, I'd have lived in Rome. Where else? Today America is the Roman Empire and New York is Rome itself." John Lennon
I’ve just spent a week in New York, visiting companies and trying to get a feel for what’s going on in America. New York isn’t the US, of course; it’s not even the capital. It is, however, now the real seat of power, as the blocked-off streets around Trump Tower testify.
But whatever the distortions of seeing the US from the Big Apple, it does give you some idea of what’s happening to the country as a whole.
It’s a big country. But its market is even bigger. The US now accounts for 55% of the world’s market capitalisation. That’s not far from the level of Japan in 1990. And look what happened there. All empires grow decadent eventually. So are there signs of decadence in the American Empire?
Well, there are certainly major changes underway. One theme that came through clearly was the depopulation of rural areas and the rise of the megacities. Various rural areas are advertising bursaries to tempt graduates back from the big cities. The shift to megacities is a global phenomenon, and the US is no exception.
Whenever I visit New York, I always keep an eye out for the fads – because where New York leads, the rest of the world very often follows. Fifteen years ago, the fads in evidence were the Atkins diet, the Blackberry and the iPod – all of which went global soon after. This time, the most obvious fad was the salad bar. Salad was everywhere – tossed with any of a myriad of dressings, most of which looked sufficiently calorific to offset any health benefits.
"The US now accounts for 55% of the world’s market capitalisation. That’s not far from the level of Japan in 1990. And look what happened there"
Alasdair McKinnon, The Scottish Investment Trust
What interested me most, though – and ruffled feathers when I mentioned it – was the fondness of my fellow investment professionals for technology and growth stories: basically, the pursuit of growth at any price – even at the expense of actually making money. Many of today’s start-up brands are sustained by an endless flood of cheap funding – a product of the decade-long experiment in quantitative easing.
There’s certainly a degree of blind faith in disruption. During my trip, I spoke to the toothpaste manufacturer Colgate-Palmolive. The company pointed out that its toothpastes and those of its big-name rivals are, demonstrably and scientifically, the best in the business. But that hasn’t stopped the appearance of niche toothpaste start-ups, even though their products don’t work particularly well.
Another good example comes from the shaving market where Gillette has long dominated through its technically excellent products, sold at ever increasing prices. The expense of shaving may be one reason for the rise of beards in recent years! A potential disruptor
"One area in which I detected robustness rather than decadence, though, was retail"
Alasdair McKinnon, The Scottish Investment Trust
loomed in the form of Dollar Shave Club, which supplies cheap shaving products on a subscription model. Its razors aren’t nearly as good as Gillette’s. But that didn’t stop Unilever paying a cool $1 billion to buy the business with no immediate plan to make profits. It simply wanted to grow.
I saw lots of odd niche products being heavily advertised during my visit – fresh dogfood, for example, which requires special fridges in supermarkets. I’m sure it’s very appetising for the dogs, but it appears to be yet more evidence that raising cash has just been far too easy.
It is safe to conclude that growth fuelled by lavish advertising spending will never be sustainable. Those ventures can only exist because of cheap money. And with that gradually coming to an end as the Fed raises rates, it will be interesting to see how this particular symptom of decadence plays out.
One area in which I detected robustness rather than decadence, though, was retail. My visit allowed me to sample the shops in Manhattan. I was particularly impressed by Macy’s flagship department store, which seemed to offer just about every product and brand you could want. It was easy to see how you could succumb to ‘Costco syndrome’ in such a place – buying much more than you initially planned.
And that helps to explain why traditional retailers are doing much better than many expected in the face of the threat from e-commerce. Now that retail chains have added online platforms to their bricks-and-mortar stores, which offer convenience to consumers through central locations and easy returns, they are increasingly achieving ‘best of both’ status.
With more money in their pockets as wages rise, US consumers are spending again, and the likes of Macy’s are well placed to benefit. The share prices of US retailers have shown signs of life recently, as investors begin to reassess their prospects.
It’s hard to sum up such a huge and varied market as the US. But while retail appears to be reviving, other sectors remind me of Wile E. Coyote running off a cliff – the legs are still going, but there’s not much holding them up. Investors’ indiscriminate appetite for technology and for growth at all costs might need to be drastically reappraised as the era of cheap money comes to an end.
"Investors’ indiscriminate appetite for technology and for growth at all costs might need to be drastically reappraised as the era of cheap money comes to an end"
Alasdair McKinnon, The Scottish Investment Trust
A final thought: one thing that struck me when visiting various company headquarters was just how commonplace ‘Summer Fridays’ have become. Employees can take a half or full day off every Friday during the summer. In many ways, this is a good thing. But I’m fairly sure that the same companies’ factory workers won’t be getting this perk in Indonesia or other low wage economies. Despite a feeling that the market’s current complacency is probably misplaced, there are, for contrarian investors like us, plenty of great opportunities in the US.
Three ways the industry is changing
Investment companies have been around for 150 years, but the last 20 have seen particularly rapid change
It’s likely you’ll have a certain image of investment companies in your head. But the pace of change in the industry is picking up. The investment companies of today are significantly different to those of 10 or 20 years ago.
This should be no surprise. Investment companies celebrated their 150th birthday this year, and nothing survives for 150 years without change. To quote Paul Niven, manager of the original investment company, Foreign & Colonial, they have gone from investing in the Amazon to investing in Amazon.com.
The last 20 years have thrown up both challenges and opportunities. On the challenge side of the equation, there’s been the rise of passive investing, and the consolidation of traditional investment company buyers into larger and larger groups, with ever greater liquidity demands.
Then there’s the opportunities. The income advantages of investment companies, such as the ability to smooth dividends, have come to the fore in an era of ultra-low interest rates. New, illiquid asset classes have sprung up that can only be held in a closed-ended structure.
There are three changes in particular that are shaking up the investment company industry at the moment, which industry professionals need to be aware of.
1. Alternatives have gone mainstream
In 1999, less than a fifth of investment company assets were invested in alternative asset classes. By 2006, it was around a quarter. Today, it’s nearly half.
Entirely new asset classes and AIC sectors have sprung up, such as specialist debt, direct property, infrastructure, leasing and ‘flexible’ investment.
Most of these focus on illiquid assets, where investment companies have a clear advantage. The perils of holding such assets in open-ended funds were laid bare in 2008 and 2016 when property funds were forced to suspend trading.
Average yields for ‘alternative’ sectors
The biggest driver of the growth of ‘alternative’ sectors is, without doubt, the hunger for income that comes from a decade of near-zero interest rates. Yields of 5% or 6% are naturally attractive, especially for assets whose income streams are not correlated to the business cycle.
That said, track records in some of these asset classes are short, and they need to be better understood. The AIC is increasing the quantity of training it is providing in these areas.
2. Discount controls are now the norm
When innovations work, they can soon become standard practice. The change in tax law in 1999 that allowed investment trusts to buy back their own shares is a case in point. Now about three-quarters of investment companies have some form of discount control policy.
Discount control policies provide a kind of safety net when there is a lull in demand for an investment company. As the discount widens, the investment company buys back its own shares, thus adding demand, raising the share price and reducing the discount.
Some investment companies are fortunate enough to have the opposite problem: persistent premiums. A gradual issue of new shares can keep this under control.
If you’re thinking that this ability to buy back or issue shares makes investment companies a bit more like open-ended funds, you’re probably right. But discount control policies have their limits, and won’t be operated in extreme market
"Most investment company investors and analysts agree that the wider use of discount control policies has been helpful for shareholders"
conditions (for example, a sudden collapse in demand). They are exercised at the discretion of the company’s independent board, who need to seek shareholders’ authority to buy back or issue shares.
Only a handful of investment companies have set themselves the challenging task of eliminating discounts or premiums altogether through so-called ‘zero discount policies’. Most investment companies with such policies merely want to keep the discount within an acceptable range, reducing volatility and giving shareholders a smoother experience.
Most investment company investors and analysts agree that the wider use of discount control policies has been helpful for shareholders, and most new investment companies are launched with such arrangements in place.
3. Fees are falling
By knocking commission off the fees of open-ended funds, the Retail Distribution Review (RDR) set investment companies a challenge. In response, 41% of investment companies have changed their fees since 1 January 2013 – a total of 176 changes, or 32 a year.
"41% of investment companies have changed their fees since 1 January 2013 – a total of 176 changes, or 32 a year"
The most common fee changes are a reduction in base fees, the removal of performance fees and the introduction of tiered fees.
Most common types of fee change since 2013*
*Source: AIC. Fee changes in period 1/1/13 to 10/4/18 inclusive.
All these fee changes are negotiated by the investment companies’ independent boards, who are tasked with getting the best possible deal on shareholders’ behalf.
Fee changes, discount control policies and the rise of alternatives may be the most noticeable changes in the industry, but there are others: a move towards mainstream investment companies investing in unquoted companies, for example. All of these changes aim to keep investment companies fresh, competitive and relevant as this 150-year-old industry seeks to reinvent itself for the 21st century and beyond.
The AIC is running four training seminars around the UK on investment companies to keep financial advisers and wealth managers up to speed with how the industry is changing. You can find out more here or register for a free place.