Looking through a long-term lens: Can investment trusts help decode today’s markets?

Investment Week asked Paul Niven of F&C Investment Trust – the world’s oldest investment trust – about the advantages of a long-term mindset, the art of late-cycle gearing, and latest tussle between ‘value’ and ‘growth’

Paul Niven

Managing Director, Portfolio Manager and Head of Portfolio Management, Multi Asset Solutions

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Risk Disclaimer

Capital is at risk. The value of an investment is dependent on the supply and demand for the trust’s shares rather than its underlying assets. The value of the investment will not be the same as the value of the trust’s underlying assets.

Past performance should not be seen as an indication of future performance. The views and opinions expressed in this article by the author do not necessarily represent those of BMO Global Asset Management.

Investment Week asked Paul Niven of F&C Investment Trust – the world’s oldest investment trust – about the advantages of a long-term mindset, the art of late-cycle gearing, and latest tussle between ‘value’ and ‘growth’

What is driving the recent popularity of investment trusts?

In part, asset growth in the investment trust space is linked to a rise in interest in alternatives. The closed-ended nature of investment trusts makes them a natural home for illiquid or longterm investments. Managers don’t have to deal with inflows or outflows, so there’s a pool of capital and you can take a very long-term view. Some of the growth has been income-focused partly because interest rates have been very low and people are looking for alternative sources of yield. But assets have been growing in the equity space, too. I think this relates to the increasing recognition of the advantages the trust structure brings, evidenced by often superior outcomes relative to comparable open-ended funds.

How do you differentiate yourself from other trusts?

First, we make full use of the advantages a trust structure provides, for example, we’ve got a very long history of investing into unlisted private equity markets. Some other trusts do that in the global growth space but not many. It means F&CIT provides a one-stop shop for investors looking for a diversified global solution with access to listed and unlisted equity markets and therefore growth assets.  Second, we can use strategies and fund managers within BMO but also third-party managers to access opportunities – an unusual blend of internal and external. Third, scale is also important. If we are talking to intermediaries like wealth managers, many of those wealth managers will not look at investment trusts below a certain size because they need liquidity. We can provide that liquidity. The broader point is that when you make any investment you have to think about the appropriate investment horizon, particularly if you’re dealing with illiquid underlying assets. Trusts trade on a daily basis and you get a ticker, but that doesn’t mean there’s always a lot of liquidity in the stock. Therefore the size of the trust is important.

What else do advisers and wealth managers need to keep in mind when investing in trusts this late in the cycle?

One obvious point concerns gearing, because trusts can borrow to invest. In rising markets, gearing tends to accentuate returns and if markets decline, it tends to exacerbate losses. The gearing levels of the trust have to be  managed appropriately because if you’re highly geared in a declining market it can also lead to breach of covenant in terms of lenders. That’s clearly serious. Also the trust share price is a function of supply and demand and may diverge from the underlying net asset value (NAV), generating a premium or a discount. In times of stress, you will not suffer gating, which you could in an open-ended fund, but you may only be able to deal at a price further from the NAV than you would like.

What is your own approach to gearing?

Our gearing levels are about 7% at the present time, or reasonably modest by historic standards. We can borrow up to 20% of net assets so we’re at the lower end of the range. The level of gearing is important but so is the spread of borrowings. If you invest in a portfolio of illiquid assets but have very short-term borrowings, you’re mismatched on liquidity. The trust might not be able to get refinancing – a real issue, clearly. So at F&CIT we’ve got a broad spread of maturities from short term – one to 12 months – to borrowings that extend out to about 40 years. That very diversified borrowing reduces our refinancing risk.

How do you balance the goals of capital growth versus income?

Our overriding objective is long-term growth in both capital and income. On the latter point, we have created a dividend every single year since we were listed in 1868 – no other listed company in the UK has paid a dividend as consistently as we have. We’ve paid rising dividends in each of the last 48 years. We’re not a high yielding company – our yield is about 1.6% – but our shareholders look to us for consistent rises in income which exceed inflation through time. That’s a key objective for the Trust. However, one of the benefits of an investment trust structure is that you can put aside revenue in the good times. That means that we can provide income in leaner times when revenues are not as strong. It also means we don’t have to sacrifice capital in order to deliver income. By contrast, many income investors have performed poorly recently because they’ve been chasing income for its own sake. The right way to approach investments in my view is to focus on total return and then distribute in a manner appropriate to your shareholders.

Where do you sit in the value-versus growth debate?

In contrast to some of our competitors, we have not nailed our colours to the mast as being an out-and-out growth fund or an out-and-out value fund. That said, we have had a bit of a growth tilt in recent years and that’s been beneficial. Growth as a style has been in the ascendancy for the last decade. But value investors are strongly suggesting that the turn will now come for cheaper stocks. I think you have to acknowledge that the growth trend has run pretty far and valuations of some of the big growth stocks are looking a little bit full so the picture may become more balanced going forward. But for a sustained turn towards value, interest rates will probably have to be on a rising trend. More fundamentally, the idea that value stocks look cheap is based upon historic comparators that have some form of mean reversion built in. Value investors are assuming that their industries, or their stocks, are not fundamentally challenged on an ongoing basis. A stock might look cheap but if the earnings are not growing particularly strongly, it doesn’t necessarily reflect value. You need to think about the value of the business in a more holistic sense, rather than the simple P/E and income yields a lot of investors look to.

So you have the flexibility to adjust the tilt of the portfolio if you wanted to, as markets evolve?

Yes, exactly, the market has cycles: momentum or growth tends to work for a long period of time, then won’t work as well. Value works for a period of time, and then won’t work for a period of time. We position the portfolio so we’ve got some tailwinds that work over the longer term, balanced towards momentum or growth, value and quality, depending upon how we view the cycle.

Is global diversification an important part of your offering to investors?

We are 90-95% plus retail owned. Most of those investors are not assembling a whole range of funds to balance out portfolio exposures. So we are providing a service to them. They entrust us with the important decisions of where to invest across listed equities and private equity in terms of regions, sectors, styles, managers, etc. Our shareholders do not expect us to place all of our capital on one potential outcome, e.g., growth or value, Japan or the UK. They expect us to adopt a conservative and diversified approach.

You see yourself as a long-term investor but what does that mean and what difference does it make?

It is a very interesting point. We are long-term investors in the sense that we’ve been running a long time and made our first equity investments in 1925. We invested in Shell in 1925 and still own that company today. But a long-term mindset does not mean that you hold on regardless. For us, “long-term” is about delivery of longterm returns for shareholders as much as it is about dealing with companies and management on a long-term basis. We do engage with companies on a long-term basis but the approach is variable across underlying strategies. For example, our private equity portfolio is clearly long term because we expect to hold thosepositions for more than a decade. On the listed side, the holding period will vary, depending on the way the manager runs the underlying portfolio. Here’s a couple of examples. We invested in Amazon in 2006 when it was trading in $30s. It’s now about $1,800 so we’ve held that stock a long time and it’s done well for us. Facebook we invested in through private markets in 2005 when it was a $100 million company and Mark Zuckerberg was only 21. We made 380 times our money on that investment prior to listing and it is now a $500 billion company.

Can you name one way for investors to improve their view of global equity markets?

It’s a good idea to look at equities through different lenses. If you buy Apple, then you can think of that as a US company; as a technology company, supplying consumer goods; as a growth company, perhaps; or some people might actually view it as a value company. So the domicile, the sector, and the style of underlying holdings is something that you need to consider. A lot of people talk about US equity markets, especially, being expensive. The reality is that when you’re buying the US equity market, you’re buying a very, very different basket of shares than if you buy into the UK or European market. The US market has an inherently higher weighting in technology and related industries. It’s a much more growth-heavy market than Europe, whichhas more cheap financials and banks. So geographic preferences are related to sectoral preferences, which are related to style preferences, and factor preferences. You need to think beyond the headlines and broad monikers when allocating capital. A lot of managers talk about themselves as ‘bottom up’ stock pickers. But if the ‘best’ stocks are all picked from one particular area like technology, or from a particular geography, you’re taking a very specific style or regional decision. That is critical in terms of understanding likely outcomes and risks.

Do the big strategic decisions at the trust rest with you personally?

I’m the lead manager but the board is ultimately responsible for the long-term trust strategy and I work very closely with them to lay out, articulate and agree that strategy: Where we invest, how we invest and so on. Structural gearing decisions also rest with the board but, again, I work very closely with them. The day-to-day management of the portfolio is down to me, really. A good example of how it comes together is private equity. We’ve got a long history in private equity but we stopped committing to our third-party managers in 2008. I got involved with the trust in 2014 and I proposed, and the board agreed, that we should recommit to private equity. Then it was down to me to go and find the right partners and deals. Private equity has a tremendous amount of capital allocated to it with a lot of that capital chasing the big deals. So we look for opportunities unavailable in the public market space with a focus on mid-market opportunities. The growth opportunities are higher and the pricing better.

Is your glass half full or half empty on global equities?

Half full. One of the big questions investors need to answer is whether there will be a recession or not – more specifically, sustained earnings contraction. And my sense is that we’re going to remain at a sufficient level of growth to avoid slipping into, importantly, a US recession. If you’ve got that view, then equity markets should do reasonably well. Valuations are not cheap but we might hope for earnings growth to get back on a more positive trend in 2020. Longer term, I think equities continue to offer relative value compared to other asset classes. Those really bearish on valuations make many assumptions about mean reversion in margins, profitability and earnings that may prove to be misplaced. One reason is that competition has been declining in almost every industry we can see. Bigger players have become more dominant and across virtually every sector of the economy there’s a much higher proportion of sales revenues from the top four or top 10 companies than was true 10 or 20 years ago. These larger firms are also more dominant in terms of employment. One curious anomaly in recent years is that the labour market has been tight but wage pressures low. Partly that’s because employees have got fewer options in terms of employers, so owners of capital are likely to continue to do relatively well at the expense of labour. That creates huge issues for society in terms of winners and losers; long term maybe something has to change. But in the short to medium term, I don’t think that there’s sufficient will to change those trends.

Any ‘red flag’ issues out there that might make you rethink your stance on global equity markets?

The US national account data is presenting more of a slowdown in corporate earnings than the US listed corporate sector. One reason for this anomaly might be that listed companies are more adept at manipulating reported earnings. That’s a concern because you’re then buying stocks on the basis of a bit of a fantasy, in terms of the earnings backdrop. The other potential explanation relates partly to the competition issue we just discussed, in the sense that national data reflects the whole economy. It might be that listed companies are taking market share from unlisted companies, which tend to be smaller. But squaring that circle remains an issue, going forward.

Risk Disclaimer

Capital is at risk.

The value of an investment is dependent on the supply and demand for the trust’s shares rather than its underlying assets. The value of the investment will not be the same as the value of the trust’s underlying assets.

Past performance should not be seen as an indication of future performance.

The views and opinions expressed in this article by the author do not necessarily represent those of BMO Global Asset Management.

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