Edinburgh Investment Trust owns a portfolio of mainly UK stocks, supplemented by up to 20% listed abroad, and aims to outperform the FTSE All Share on an NAV basis while providing a dividend that grows faster than inflation.
Manager Mark Barnett uses a value approach to picking stocks, and so takes contrarian positions in companies, sectors and themes which are out of favour in the market. This can cause the performance to deviate significantly from the index, and has led to underperformance since the 2016 Brexit referendum.
Currently Mark has tilted the portfolio to stocks with UK earnings, which he thinks are undervalued as the market is too pessimistic about the prospects for the UK economy.
Mark looks for businesses with the ability to maintain or grow their dividends, and the result is a portfolio with an attractive yield of 3.9% and a dividend that is well-covered by reserves, meaning he should be able to grow the dividend in future years.
The current discount of c.9% is wider than the one-year average of 8% and the weighted sector average of 4.2%, following the underperformance since mid-2016.
Value investing is the basis of Mark’s investment approach. He seeks to buy companies that are undervalued by the market, believing that over the long run this will lead to outperformance of the index. Mark looks for businesses with the ability to maintain or grow their dividends, and aims to buy and hold for the long run, being patient when the market moves against his stock picks.
The focus is on dividends as Mark believes they are a tangible indication of the strength of the company and that over the long run they are the biggest source of investors’ returns. He also believes this makes him more transparent and accountable to shareholders.
Mark is benchmark-agnostic, and the structure of the portfolio varies considerably from the index. In recent years this has led to a consistent overweight to tobacco stocks, for example, with the trust holding over 12% of its portfolio there compared to its 6% weight in the index.
Mark has used his ability to buy foreign stocks to build up this overweight – he has 3% in Altria, the parent company of the Philip Morris brand. He also held US cigarette firm Reynolds before it was bought out by BAT, another of his holdings. BAT is his largest position in this sector, and in the fund, as it is trading on a discount to its peers on a P/E basis.
The trust can invest up to 20% overseas, and Mark has used this flexibility extensively. The overseas holdings were close to the maximum until mid-2017, when they were reduced below 10%.
As well as US stocks, the trust owns Swiss pharmaceutical companies Roche and Novartis, which helps boost the trust’s second largest sector exposure, to pharmaceuticals. The trust holds 10% in healthcare, making it roughly 1% overweight.
The trust has an all-cap portfolio, with roughly 50% in the FTSE 100 and the bulk of the rest in the FTSE 250. Mark does occasionally take advantage of opportunities in niche investment trusts, such as Raven Property Group, which invests in commercial property in Russia, and P2P Global Investments, which invests in peer-to-peer loans.
At the moment, Mark sees the main opportunity in the market in stocks that are focused on the UK economy. Roughly 40% of the portfolio's revenues come from the UK, compared to just 30% for the FTSE. Mark has tilted the portfolio towards financials – the trust’s largest overweight – and to consumer cyclicals and real estate. In financials he prefers insurers to the banks, which he does not hold, and this sector also includes a number of equity investment trusts including more than one peer-to-peer lending fund. Mark believes that the uncertainty around Brexit has caused the market to become too pessimistic regarding the long-term outlook for the UK economy and to undervalue the revenue streams from these sectors.
Over three years the trust’s returns and Sharpe ratio put it in the fourth quartile in its sector - however the manager's 'value' approach has been out of style in a momentum driven growth market. The trust is top quartile for absolute and risk-adjusted returns over ten years, and although much of this was under a different manager, that manager had the same value approach as Mark did, and Mark’s other funds did extremely well during this earlier period as well.
The trust has £100m of debenture stock maturing in 2022, as well as a £150m revolving credit facility. This allows Mark to vary his overall level of exposure in accordance with his view of the market. Since the Brexit vote the gearing has drifted down as Mark has become more cautious about the prospects for the market.
In 2014 and 2015, after Mark took over management of the portfolio, returns were very strong relative to the index and sector. This was largely thanks to tobacco stocks and non-bank holdings in the financial sector. Mark steered clear of banks and miners, both of which seemed cheap, but had risks to their businesses and share prices he wasn’t prepared to take.
However, 2016 and 2017 were challenging. The trust was hurt by being heavily exposed to businesses with sterling revenues and dependency on the UK domestic economy following the June 2016 vote to leave the European Union. Mining and commodity stocks also outperformed, so the company’s zero weighting turned from a tailwind to a headwind. There were also stock specific issues with Capita, Circassia and BT.
Over five years the company is ahead of its FTSE All Share benchmark, although it has underperformed since the beginning of January 2016, a period in which the value factor has struggled against the momentum factor.
The past year has been difficult as Mark has stuck to his analysis that there is significant under-valuation in sterling revenue businesses and those exposed to the domestic UK economy.
The objective of the trust is first to outperform the FTSE All-Share Index on an NAV basis and, second, to grow dividends by more than the rate of inflation. Over the last ten years the trust has grown its dividend by 2.7% annualised, ahead of the CPI's 2% a year over that time, but just behind the RPI's 3.3%. The trust had to dip into reserves to continue to grow the dividend in 2013 and 2014 when earnings per share were flat or failed to grow as much as required; however, it had 1.58 times the 2018 dividend in reserve as of the last report and accounts.
The trust is yielding 3.8%, in line with the average for the UK equity income sector.
Mark Barnett has managed the portfolio since January 2014, when he took over from Neil Woodford. Mark was then promoted to head of UK equities, a post he continues to hold. He has 25 years' investment experience, 21 of which have been at Invesco. In July 2016, James Goldstone was appointed deputy manager of the trust. James has 16 years' experience in finance, having worked on the sell side before joining Invesco five years ago. He also runs an open-ended pan-European equity income fund as well as two other UK equity income trusts. His appointment has helped lessen the load on Mark, who had taken on a number of open- and closed-ended funds from Neil Woodford. Goldstone has since been appointed to run Keystone too.
Invesco has eight UK equity fund managers, all based in Henley-on-Thames, and all of which share a commitment to value investing as a philosophy. The managers discuss ideas together and will sometimes coordinate meetings with companies, allowing them to benefit from each other’s different perspectives.
Since early 2017 the trust has traded on a discount to its sector average. Prior to this it traded close to, and sometimes above, the discount of the sector, but a period of poor performance following the UK’s vote to leave the European Union saw the shares fall out of demand. This was due to the trust’s over-exposure to sterling revenues in a period in which the currency depreciated by 15% on a trade-weighted basis, as well as some stock-specific issues.
The board has the authority to repurchase shares in order to narrow the discount, although no formal target exists and it has been reluctant to use this power, not repurchasing any shares since 2016. However, on 2 July, a few days after the publication of the 2018 annual report, the trust did repurchase 50,000 shares as the discount slipped wider than 10%.
The OCF of 0.57% is lower than the sector average of 0.76%. Unusually the management fee, of 0.55%, is charged to market cap rather than net assets, which incentivises the manager to keep the discount narrow. Only three of the 23 other trusts in the sector charge to market cap rather than gross or net assets. The KID RIY figure of 1.21% compares favourably to the sector average of 2.38%.
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