Compass - March 2021
Is value having a resurgence? Could private equity be due a comeback? And how do you convince wannabe day traders about the power of long-term investing?
By Annabel Brodie-Smith
The daffodils are out, the birds are singing in the morning, the blossom is on the trees and life is more positive. Spring is on its way. We have a ‘roadmap’ (hate that word) out of lockdown and the boys are going back to school on Monday - hurray! We are not in our new barn home yet, but the builders are in so progress is being made.
Wednesday was Budget day where we heard about the economic consequences of the pandemic and some thoughts on how it was going to be paid for. There was an overwhelming feeling of déjà vu as everything important had been leaked before. But for SIPP (self-invested personal pension) investors the freezing of the lifetime pension allowance, currently £1.073m until 2025/26 was important. Any savings above the lifetime allowance when taken out of a SIPP could land the saver with extra tax charges of 25% if it’s taken as income or a stomping 55% if taken as a lump sum.
So Ian Cowie’s article on “growing wealthier slowly” with investment company ISAs couldn’t be more appropriate right now. The ISA limit’s £20,000 a year but there’s no nasty stealth taxes on the way out. Ian holds three of the 28 investment companies which would have made shareholders ISA millionaires at the end of January if you’d invested the full ISA limit from their introduction in 1999 to 2020. Not that we’re suggesting that would be a sensible investment strategy - it’s vital to have a diversified portfolio for the long-term to meet your investment needs.
Ian also has plenty to say about the “get rich quick schemes” hitting the headlines “ranging from bitcoins to financial flash mobs causing prices to go up like a rocket before they come down like a stick”. Ian cites the Barclays study starting from 1899 where shares representing the composition of the London Stock Exchange in any five consecutive years did better than cash 76% of the time. He says that’s slightly better than the 75% chance of losing money on Contracts For Difference (CFDs)!
Another topic that’s been hitting the headlines is inflation, or more accurately the prospect of higher inflation, as 10-year US treasury rates rise. Markets have been concerned about this and growth stocks have slid. Could this be the time for value investing to shine? A value investment strategy, to remind you, is where a manager buys stocks at a significant discount to their intrinsic value. Our value-orientated managers have plenty to say about the growth-to-value rotation, the impact of COVID-19, inflation and where they are finding opportunities. Find out more from the managers of Temple Bar, Fidelity Special Values, Scottish Investment Trust, Edinburgh Investment Trust and Seneca Global Income and Growth Trust (soon to be renamed Momentum Multi-Asset Value Trust).
Another area which could offer value to investors according to analysts at Stifel is private equity investment trusts. Stifel suggested 2020 results could be “remarkably good” considering the backdrop of economic recession and business shutdowns. To find out more about “one of few routes into the exciting and dynamic unquoted companies space for retail investors” read freelancer Hannah Smith’s article.
Finally, with the end of the tax year in sight you might be interested in watching our latest animated video on the right. It explains what venture capital trusts (VCTs) are, what they invest in, the risks and tax breaks on offer. It also has jaunty jazz music and fun animations including fireworks and a flower.
So this month I am starting and ending this foreword with flowers. Hope everything’s coming up roses with you.
Communications Director, AIC
Ian Cowie ditches bitcoin for investment companies
‘Get rich quick’ schemes have hit the headlines recently, ranging from bitcoins to financial flash mobs causing prices to go up like a rocket before they come down like a stick. Speaking from personal experience, I would say the truth for most serious investors will be less dramatic but more profitable.
In plain English, anyone who wants to become wealthy should be prepared for it to take longer than some headlines might suggest. To understand why, there is no need to get bogged down in the details of distributed ledger technology (DLT) – the idea behind most virtual currencies – or Contracts For Difference (CFDs) and spread-betting, the financial derivatives favoured by online flash mobs. All you need to do is read the warnings the regulatory authorities require websites that promote these wheezes to display, albeit usually at the bottom of the page in small print.
For example, one outfit that describes itself as “the UK’s No. 1” admits: “75% of retail investor accounts lose money when trading spread bets and CFDs with this provider.”
That’s the mirror image of what medium to long-term investors in British shares have received over the last century and more. There’s no need to take my word for this, Barclays Bank has studied returns from various assets since 1899, when Queen Victoria was still on the throne.
Shares reflecting the changing composition of the London Stock Exchange over any period of five consecutive years since then did better than cash 76% of the time. That’s marginally higher than a three-in-four probability of winning, compared to CFDs’ three-in-four likelihood of losing.
I know which I prefer. If you could remain invested in shares for ten consecutive years, the probability of beating cash soared to 91%, according to the Barclays Equity Gilt Study 2020.
Time is the key ingredient, combined with investors who are willing and able to accept that share prices will fluctuate without warning and we may get back less than we invest – especially if we sell when prices are temporarily depressed. Fortunately, one form of pooled fund – the investment company – makes it easy and convenient to take a medium to long-term view of equities’ volatility, without any worries about being forced to switch into cash when markets are depressed.
That’s why I was delighted to see three of the investment companies I have held for more than a decade featuring in new research. This showed how investing the annual individual savings account (ISA) allowance since this tax shelter was set up in 1999 would have madeshareholders millionaires today.
No fewer than 28 investment companies turned these ISA allowances – worth a total of £246,560 – into more than £1m, and eight of them finished the period worth more than £1.5m at the end of January. Scottish Mortgage (stock market ticker: SMT) is the standout success story with a tax-free pot worth £2,541,100 by 31 January 2021.
My long-term winners are Polar Capital Technology (PCT); Worldwide Healthcare (WWH); and Baillie Gifford Shin Nippon (BGS). Although none of them is in my ISA or worth £1m on its own, they all helped my self-invested personal pension (SIPP) soar into a seven-figure valuation.
Never mind the past or the present, what about the future? The sooner you start to invest, the more time you have to make your money grow.
Lest that sound a bit broad-brush, here’s a financial parable about fictitious twin sisters, Prudence and Extravaganza, based on mathematical fact. It shows how compounding can do the heavy lifting for wealth creation over long periods of time.
Prudence invests £100 a month from age 18 to 38 and then stops saving altogether. She achieves an average of 5% annual growth for the 20 years she invests and her fund continues to grow at 5% for the next 27 years until she retires at 65.
Extravaganza fritters away her money on frocks and handbags, saving nothing until she is 38. Then she starts saving £100 a month — until she, too, is 65. Extravaganza also achieves 5% a year during the 27 years she is investing.
At 18, both had nothing. When Prudence reaches 38 she has pension savings of £41,000. Extravaganza has zilch. Now, here’s the point of the tale: at age 65, Prudence has £145,795. Extravaganza has just £68,219.
So Prudence has more than twice as much at retirement as Extravaganza, even though Prudence set aside a total of only £24,000, while Extravaganza invested £32,400. The explanation is that Prudence invested for 20 years before Extravaganza got going and those early pounds had another 27 years to grow in the sensible sister’s fund. Similar but smaller effects can be seen over shorter periods of time.
This isn’t the sort of thing they teach at school – but perhaps it should be. If it was, City cynics might not be able to joke that compound interest is earned by investors who understand it – and paid by people who don’t.
The only practical option is to take an active interest in serious investment - as opposed to ‘get rich quick’ schemes’ - and the sooner we start the better. It might not make for exciting headlines but this long-term investor sincerely believes it is better to grow wealthier slowly than to go bust quickly.
Value managers on why it could be time for unloved equities to shine
The age-old investment debate about ‘cheap’ value stocks versus ‘expensive’ growth stocks shows no sign of going away. Whilst there is no doubt that growth strategies have been the winners over the past decade, predictions of a post-pandemic recovery and possible inflationary pressures could suit more value-orientated approaches.
But what does the future hold for value, will these types of stocks provide a hedge against inflation, and where are value-orientated managers finding opportunities? The AIC has asked the managers of value-focused investment companies for their thoughts.
Value stocks and COVID-19
Ian Lance, Co-Manager of Temple Bar Investment Trust, said: “The portfolio suffered at the start of the pandemic but has recovered very strongly since the first news on vaccines. We had used the volatility in the market during 2020 to buy stocks that looked very undervalued if any sort of economic recovery occurred, and these stocks have done well during the last four months.”
James de Uphaugh, Manager of Edinburgh Investment Trust, said: “We are flexible investors and we have endeavoured to morph the portfolio as we have gone through the different chapters of the COVID crisis. For a brief gut-wrenching period it was all about ‘days of liquidity’ but quickly our team’s analysis pivoted to ensuring that we were invested in companies that had clear plans to emerge strongly on the front foot into radically changed competitive environments. So purchases included the likes of Greggs, Compass, Easyjet and Dunelm. These were funded by sales of the likes of Glaxo, Sage and Barrick Gold. Since taking on this prestigious mandate until the end of January 2021 we have outperformed and the discount has narrowed. Two encouraging initial proof points in what is a long-term project for the team at Majedie.”
Alex Wright, Manager of Fidelity Special Values, said: “While our portfolio was defensively positioned going into the pandemic, our holdings were not immune and a few, like aerospace equipment supplier Meggitt and alcoholic drink manufacturer and distributor C&C Group, two normally resilient businesses, have been severely impacted by the disruptions.
“But what we have also been finding is that the resulting recession is different from any other that we have seen previously. Unusually, consumers have not been able to spend as much as they would normally due to lockdowns and other containment measures still in place. So, they are spending considerably less on transport and travel, leisure activities and eating out – normally a substantial share of their spending – leaving them with more disposable income to spend on housing, DIY, electronics and sports equipment and clothing. This trend has benefited our holdings in specialist retailers such as Halfords, Dixons Carphone, Studio Retail Group and Frasers Group, which have been reporting stronger-than-anticipated trading.”
Gary Moglione, Fund Manager of Seneca Global Income and Growth Trust (soon to be renamed Momentum Multi-Asset Value Trust), said: “Inflation expectations have been low for years with the main talking point being deflation. In that environment, investors seek growth businesses or dominant market players with a strong franchise and dependable cash flows. The consensus view has now changed significantly as markets start to reflect the expectation of inflation. The yield curve is steepening which indicates the market is expecting higher inflation and thus higher interest rates in the future and this view is difficult to argue against. We have had massive amounts of stimulus into the global economy, loose monetary policy and lots of pent-up consumer demand as people have been confined to their homes for the best part of a year. If the vaccine rollout is a success, then this should equate to a strong recovery and pressure on prices. I would point to research from Fama and French and William J Bernstein which has charted the correlation of inflation and the performance of value.”
Alasdair McKinnon, Manager of The Scottish Investment Trust, said: “Central banks are indicating their willingness to tolerate greater inflation. And while governments can’t say it out loud, they would secretly love to devalue the debt burdens that they have accumulated during the pandemic. Historically, ‘value’ fared well in inflationary conditions. This is when a ‘bird in the hand’ is suddenly worth more than ‘two in a bush’.”
James de Uphaugh, Manager of Edinburgh Investment Trust, said: “Growth stocks have outperformed since 2009. The result is that the valuation differential between growth and value is at extremes. If inflation increases and bond yields rise then the combination of a likely less accommodative Fed and higher discount rates is likely to impact the valuation of growth stocks more than value stocks. In that event value stocks would provide something of a hedge.”
Ian Lance, Co-Manager of Temple Bar Investment Trust, said: “There are many signs that economic recovery, combined with massive monetary and fiscal stimulus, could lead to inflation as newly created money finds its way into the real economy rather than just financial assets. Historically, value as a style has done well in this type of environment as sectors such as energy, mining and financials fare well during reflation/inflation.”
Alex Wright, Manager of Fidelity Special Values, said: “The UK market – and in particular the value segment of the market – offers very attractive opportunities. While we have started to see a rotation into value in late 2020, the dispersion in returns between growth and value stocks since the 2008-2009 global financial crisis remains unprecedented. This leads us to believe that, should investors shift their focus for the reasons mentioned previously, the degree of outperformance could be very substantial, given how bifurcated the market currently is. We are particularly optimistic on the medium-term outlook not only due to the number of investment opportunities on offer and their upside potential, but also because we are not having to compromise on quality.”
Ian Lance, Co-Manager of Temple Bar Investment Trust, said: “Value as a style has significantly outpaced growth over the last few months but we believe that very few investors have started to reposition themselves and hence we believe that the rotation will continue, in particular in the face of an economic recovery or pick-up in inflation.”
Gary Moglione, Fund Manager of Seneca Global Income and Growth Trust (soon to be renamed Momentum Multi-Asset Value Trust), said: “History doesn’t repeat itself, but it often rhymes. We are now over a decade into one of the strongest periods for growth stocks ever. Valuation spreads between value and growth reached extremes in 2020. We have seen cycles like this before with the Nifty Fifty in the 1970s and the Tech Boom in the 1990s. You can look through history and see that whenever we have a period of strong outperformance of growth the market eventually rotates to an exceptionally strong period of value performance. These cycles usually range from a couple of years to a decade, so this period for growth has been exceptionally long. Many investors aged under 35 have effectively only witnessed one market during their careers. To evidence the belief that “this time it’s different” over the past year or two there have been many articles entitled “Is Value Dead?” This is the recency effect and a common behavioural bias that people weigh recent experience much more heavily than distant experiences. As value has had a poor decade, people question its validity more and more. You can google “Is Value Dead? 1999” and see that exactly the same articles, even with the same title, were being written in 1999 just before one of history’s strongest rotations from growth to value.”
James de Uphaugh, Manager of Edinburgh Investment Trust, said: “Our view that inflation expectations are on a probable upward trend leads to us holding banks such as NatWest and commodity companies such as Anglo American, which is pivoting to commodities such as copper, crucial for the electrification necessary if the world is to achieve environmentally sustainable growth. Elsewhere, we have supported equity raises in the likes of Polypipe, which is in the sweet spot of sustainability and is illustrative of how in each of our holdings we integrate ESG into the investment decision.
“A global risk we are concerned about is that the economy accelerates so strongly in late 2021 that it puts upward pressure on inflation and bond yields forcing central bankers’ hands. Then, just as declining bond yields were so important in powering stocks in 2020, the reverse could happen, as policy makers cut back on liquidity. This would put pressure on equity valuations.”
Alasdair McKinnon, Manager of The Scottish Investment Trust, said: “Going forward, we see stocks that are able to pass on price rises in a timely manner as best placed. Even better, these ‘value’ stocks are severely out of favour. Banks (Santander, Lloyds), energy (BP, Shell) and miners could all be beneficiaries of this. We have also added to some of the most impacted industries like the high street, where we find some restaurants and clothing retailers with good brands and balance sheets that we think will allow them to re-emerge from the pandemic as long-term winners. Some of our largest holdings are gold miners, including Newmont and Barrick Gold – you can’t print gold and we expect its value to increase in line with the ballooning money supply.”
Ian Lance, Co-Manager of Temple Bar Investment Trust, said: “We are finding opportunities in energy (BP), materials (Anglo American), financials (NatWest Group) and consumer cyclicals (Marks & Spencer). One of the greatest risks is the enormous over-valuation of the US stock market combined with signs of speculative behaviour that are often associated with a market peak. A second one is the risk that central banks will fail to react as inflation increases and that inflation may get out of control.”
Alex Wright, Manager of Fidelity Special Values, said: “We have significantly increased our exposure to specialist retailers (Halfords), car distributors (Inchcape), DIY stocks (Kingfisher) as well as housebuilders (Redrow and Vistry). These are all areas that are seeing increased demand as households reassess their priorities and, importantly, where we believe the changing dynamics caused by the virus are likely to be longer lasting than currently factored in. We continue to favour life insurers, which are well regulated companies with good risk management and which are seeing strong demand for bulk annuities and pension de-risking. The sector offers an attractive combination of cheap valuations, strong demand/supply fundamentals and growing earnings. Our largest holdings in the space are Legal & General and Aviva.
“Conversely, we are underweight mainstream banks. While cheap, they lack a medium-term catalyst to re-rate given the low interest rate environment. Instead, we have bought into UK-listed emerging market financials Bank of Georgia, TBC Bank and Kaspi, which are able to generate strong returns in the current interest rate environment but have been overlooked or lumped in with the mainstream banks. We are also underweight energy having sold down our exposure to UK oil majors Shell and BP, which have cut their dividends and are embarking on a complex and high-risk transition towards a more diverse energy mix.”
Gary Moglione, Fund Manager of Seneca Global Income and Growth Trust (soon to be renamed Momentum Multi-Asset Value Trust), said: “One stock which we think will do well is UK Mortgages (UKML). UKML had a difficult start after launch as market conditions meant they did not invest the initial capital very quickly which led to an uncovered dividend and a declining NAV. They took a new strategic direction last year and are now focusing on the higher yielding mortgage books whilst selling the lower yielding. They essentially buy or initiate mortgages and when the number of loans reaches a reasonable size they will securitise them, locking in returns and freeing up capital to initiate more mortgages. The trust has traded on a significant discount and the managers and board have worked hard to close that from a peak of 47% in April 2020 to less than 10% today with an aggressive buyback policy. The dividend, which at the current price is 6%, is now covered and they are also projecting NAV growth with their latest securitisation anticipated to generate mid-teen internal rates of return. A second value play is Ediston Property Investment Company (EPIC). This trust focuses on out-of-town retail parks. The property market has been ravaged by COVID as many retailers struggle and some use company voluntary arrangements to force landlords to accept lower rents.”
Why private equity could surprise in 2021
Private equity investment trusts are one of few routes into the exciting and dynamic unquoted companies space for retail investors, and they have historically traded on hefty discounts. But research house Stifel has tipped these trusts to surprise this year, so is now a good time for investors to look at private equity again, and what risks do they need to consider?
In a recent research note, Stifel’s analysts suggested 2020 results could be “remarkably good” considering the backdrop of economic recession and business shutdowns. “With the reporting season imminent, we think private equity sector NAVs may well surprise on the upside. When combined with the relatively large discounts many of the funds are trading on, this makes the sector look attractive.”
One reason for this is that many private equity funds have significant exposure to healthcare and technology sectors which have been strong performers, especially in the fourth quarter of 2020. Seven funds have more than 30% of their NAV in these sectors, Stifel notes.
HgCapital, for example, was one of the best-performing trusts in the first half of last year, which Stifel says reflects its tech specialism.
Source: AIC/Morningstar. Periods to 28/02/21. Ex 3i.
Meanwhile, discounts have been consistently wide among these trusts – Stifel estimates that the average real discount is 23-28%. Why is this? Part of the reason is that investors are put off by the higher costs of some of these trusts which are structured as fund of funds and so come with layers of charges.
“Discounts have proved very stubborn over the last 10 to 12 years,” notes Investec’s director of investment companies research Alan Brierley. He adds that private equity trusts don’t tend to use share buybacks as a discount control mechanism, in contrast to other types of investment company.
The legacy of the global financial crisis
These trusts also suffered more than most in 2008/09, and have not entirely bounced back, Brierley adds. "They didn’t have a great experience during the global financial crisis as a lot of companies were over-leveraged with too many commitments, many struggled and the sector hasn’t really recovered since then.”
Investec has strong conviction in private equity trusts, however, and is currently three times overweight listed private equity compared to the wider market. Pantheon International and HarbourVest Global Private Equity have featured in its model portfolios for a number of years.
Brierley explains that these trusts allow investors to access the ‘de-equitisation’ trend, in which high-growth companies (many coming from the west coast of the US) don’t feel the need to seek capital from stock markets. “They can stay off the equity markets for a lot longer in their evolution,” he points out.
Outside the unquoted companies space are a lot of highly leveraged and growth-challenged businesses, he adds, so investors are looking for ways to reach those more appealing, less indebted companies that may be better placed to grow rapidly. "It is a real challenge for investors in general: how do you get exposure to that interesting part of the market?”
Most UK-listed private equity trusts have delivered market-beating NAV returns over the last decade, at least compared to UK indices, notes Milosz Papst, director, investment companies at Edison Group, and such a solid track record makes them look attractive long term.
Source: AIC/Morningstar. Discrete years to 28/02. Ex 3i.
Private equity trusts had been increasing their exposure to resilient sectors even before the Covid crisis took hold, in anticipation of an economic downturn following a prolonged bull run. “This should help sustain good earnings growth across their portfolio, but current NAVs are based on quite demanding public market multiples used to value most of these businesses,” says Papst.
As Papst suggests, while their exposure to tech has been a tailwind so far, private equity trusts could suffer if the sector loses momentum. Even bullish Stifel points to the risk of a “significant stock market correction, especially in the tech sector”.
For investors wanting to tap into interesting and entrepreneurial unquoted businesses, private equity investment trusts could offer a way in at a significant discount. But you might pay higher fund charges for the privilege, and bear in mind that this part of the market comes with its own risks.