Ready Player One

We wonder where, if anywhere, investors should look for returns after a tumultuous first half of the year…

 
The last six months may seem like a lifetime to investors, with the jubilation of the post-COVID economy giving way to inflationary blues, and equity markets entering the worst bear market in years. The roller coaster is not over, however, with the Ukrainian crisis yet to be resolved, inflation rampant, and supply chains restricted. Oases have been hard to find. Many real assets, alternatives and infrastructure trusts have managed to generate positive NAV returns. However, as the risk-off ride accelerated in Q2, share price total returns have turned negative for more and more trusts. Amidst the volatility, the relative safety of cash may be appealing, but that is partly due to the money illusion: £100 is going to be worth a lot less in six months than it is now. With that in mind, our team of analysts look forward to the next six months and highlight areas that could be of interest for those who share this view.
 

Quality is king | David Johnson

 
Much of the investment debate over the last six months has been framed around the notion of growth versus value, with many of the previously dominant growth stocks having seen their fortunes reverse. While value seems to be having its time in the sun, I believe that today’s buying opportunity isn’t in value or battered growth stocks but instead in the quality factor. A ‘high quality’ company can have varying definitions depending on which manager one asks, but typically it is characterised by experienced management teams with successful track records, economic moats which prevent major competition, strong brands or key products which can sustain demand, or strong balance sheets which indicate well above average financial health.

The importance of these factors should seem obvious for equity investors, as they are often the hallmarks of successful companies. Most importantly, high-quality companies are reliable. Such companies have historically been able to demonstrate resilient earnings, often with a track record which spans multiple cycles, generating profits even during recessionary periods. This, I believe, is the key opportunity in today’s markets, as something that is clearly lacking is a sense of certainty. I think that in the current environment, investors should be looking to high-quality companies, as they may have the highest likelihood of sustaining their historic earnings trajectory in the current market.

The other characteristic that quality companies have historically had is a valuation premium. Given their superior earnings, I think this can be justified: the simple fact that they can carry fewer earnings risks means investors may less aggressively discount them as a result. However, the quality factor has been punished over the last six months, swept up in the selloff of any highly valued asset thanks to the impact of rising interest rates. The team behind BlackRock Sustainable American Income (BRSA), which manages a portfolio of high quality, high yielding, US value stocks with strong ESG credentials, have found that in the US, the top quintile of companies, when ranked by quality metrics, now trade on discounts (relative to their fundamental value) not seen since 1999.

Given this combination of stable earnings and widening discounts at both a company and investment trust level, I believe quality trusts are one of the most attractive and reliable investment opportunities in the near term. One example of this opportunity is Global Smaller Companies (GSC) (previously BMO Global Smaller Companies), which offers investors a core portfolio of global small caps, with the dominant factor in the GSC’s team’s analysis being the quality of their holdings. While GSC trades on the narrowest discount of its peer group, its 12.1% discount is still an attractive entry for anyone looking to position for a flight to quality. For income investors looking to capitalise on quality, they may find European Assets Trust (EAT) to be a more attractive alternative, as the team behind EAT manages the European element of GSC’s portfolio. EAT, however, follows a policy of paying out 6% of its NAV as a dividend each year, making it one of the highest yielding quality strategies available to investors. Investors should be aware, however, that by paying income from capital this may mute some of the potential for capital growth in the trust’s shares.

Given that small caps can carry higher risks (which has exacerbated their selloff), certain investors may find the large-cap portfolio of Brunner (BUT) more attractive. Mathew Tillett , BUT’s lead manager, also follows a process that focuses overwhelmingly on quality. BUT is also characterised by a strong focus on valuations, as well as its large UK weighting, which differentiates it from many of its global equity peers and has led BUT to be one of the best performing global equity trusts over the last 12 months. Despite this performance, BUT still trades on a 12.4% discount, wider than its peer group average.
 

SONGs of praise | William Heathcoat Amory

 
New alternative investment areas sometimes take time to be properly understood by investors, and so after the honeymoon of IPOs and C-shares, sometimes trusts or sectors can find their shares suffer from a lack of a marginal buyer and sag to a discount. The catalyst for a re-rating is often simply that the market digests the proposition, the trust or trusts in question deliver on expectations, and more cautious investors will start to invest. Depending on the complexity and novelty of the strategy, this could take some time. I think this is the situation that Hipgnosis Songs Fund (SONG) – the leading trust in the music royalty sector with net assets of c. £1.5bn – finds itself in.

In my view, it is becoming increasingly clear that the music industry is experiencing a renaissance, having had a period in which piracy eroded revenues and which has now found a model which renders piracy irrelevant and provides a means to be paid for the product. This is streaming. It seems streaming providers such as Spotify and Amazon have more resilient relationships with customers than the likes of Netflix. Aside from this consideration weighing on SONG’s share price, there are more tangible positives to point to, including the recent announcement of the USA’s Copyright Royalty Board Appeal announcement, in which it has ruled on royalty rates increasing retrospectively from 10.5% in 2017 to 15.1% in 2022 and thereafter. This increase had been appealed against by streaming companies, which have hitherto been paying royalties at the 10.5% rate.

SONG has c. 36% of revenue from streaming, and JPMorgan Cazenove estimates that the underpayment since 2017 may be in the region of 5% annual income, or c. 0.4% of NAV. Going forward, the new level of income SONG expects to receive may lead to a higher NAV which JPMC estimates may be as much as 3%. There are clearly macro-economic risks on the horizon to which SONG will clearly not be immune. However, with private equity continuing to invest capital in this area, and 2022 looking set to be a strong year for live performances, I think that the investment case has not been impaired to the extent suggested by JPMC’s estimated discount of c 20%+. SONG is due to announce its NAV and results later in July, which will provide more colour and could lead to more investor interest in the shares and potentially a re-rating.
 

Standing on their own two feet… emerging markets | Helal Miah

 
There is an old saying that ‘when the US sneezes, the world catches a cold’. With many investors and economists suggesting a potential recession in the US this year (and maybe the UK and Europe), is it time to fret about your emerging markets exposure? The thing is that emerging markets have already been on a downward path since the middle of last year. However, their declines haven’t gathered much further pace since the developed market began their sell-off as energy and commodity prices spiked after Russia invaded Ukraine.

Sure, there are emerging market countries suffering lately due to food price inflation and supply constraints, but many now argue that emerging markets are far more resilient today than in the past and can on their own two feet. None more so than China, and its influence has grown so much that it rivals the US in setting the global agenda. I think the sell-off in emerging markets over the past year can largely be attributed to China and its zero-COVID-19 policy. However, now that COVID-19 restrictions are expected to ease, there could be a rebound if Chinese monetary policy is relaxed or the US eases tariffs on Chinese imports.

Emerging market commodity producers are today facing a commodity tailwind rather than a headwind, and China, the world’s biggest consumer, could act as a buffer to the slowing US and European economy. In the past, commodity producers have invariably suffered from developed market slowdowns.

Another argument for resiliency is that emerging markets themselves are now more developed. Take, for example, Taiwan, Korea, and Poland, which have experienced rapid development in their financial and legal structure. They have more similarities to Japan or Germany than developing nations. Should these continue to be classified as emerging markets (as MSCI continues to do)?

As wealth in emerging markets has increased, domestic investor capital has to some extent replaced foreign investor capital. So, a strengthening dollar may not necessarily lead to as big capital outflows as in the past. Excluding certain countries like Russia, Argentina, and Turkey, we have seen good signs with emerging market currencies which have held up well.

So, where should investors look? We suggest investors have a read of our views on Templeton Emerging Markets (TEM) or JPMorgan Emerging Markets (JMG), both of which trade at attractive discounts. Alternatively, for country-specific exposures to the two big emerging market countries, China and India, investors may want to read up on abrdn China (ACIC) and Ashoka India Equity (AIE).
 

Time to tighten the purse strings… | Nicholas Todd

 
The macroeconomic environment over the past couple of decades has led to a period of phenomenal growth. Admittedly, we have been subject to several recession-inducing periods along the way including the dot.com bubble, the great financial crisis (GFC) and of course the pandemic. However, the multi-decade-long period of deregulation across financial markets; the birth of quantitative easing (QE) and the almost unimaginable amounts of monetary and fiscal stimulus that has flooded the market, especially following the GFC and coronavirus, have had a hand in creating an environment where company valuations and asset prices have risen significantly – particularly in growthier, more speculative sectors. ‘Easy money’ has flooded the economy through numerous avenues, including a prolonged period of low-interest rates and sustained levels of QE, to fiscal support through furlough schemes, government stimulus checks and business support. This has been particularly evident across the developed economies, which has inevitably led to the support of unsustainable zombie companies, and notions such as the ‘Fed Put’ in the US.

In addition, the rise of globalisation has provided corporates with the opportunity to access cheaper labour and increased efficiencies through technological innovation leading to the compression of margins and availability of capital to further invest. This has led to an environment with very few alternatives to equities to generate investment returns. The growth of equity indices such as the MSCI All Countries World Index (ACWI), S&P 500 and the Nasdaq 100 have generated annualised NAV total returns of c. 11.4%, c. 15.8% and c. 20.1%, respectively, over the past ten years. This has made it difficult for many active portfolio managers to maintain above the benchmark, alpha-generating performance.

However, over the last 12 months, global equity markets have begun to suffer, and this myriad of factors has created a perfect storm for inflation; the interconnectivity of global markets; the reliance on ‘just in time’ manufacturing and supply-leading to bottlenecks in the supply chain; labour shortages and restriction on labour movements – leading to wage inflation; elevated savings ratios – leading to maintained levels of consumption; the Russia-Ukraine conflict – adding to upward pressures on commodity prices and monetary policy being slow too. The latest inflation prints in the US, UK and Europe, although off recent highs, have maintained historically elevated levels and should remain a key consideration for investors.

Many companies will inevitably struggle with rising input and borrowing cost pressures. In addition, individuals’ and households’ savings buffers built up during the pandemic have begun to deplete as costs are passed onto the end consumer – we enter an era where, for the majority, it is time to tighten the purse strings and protect capital. As equity-focused strategies, particularly those with a growth tilt, continue to come under pressure, I think a more flexible approach that can offer some protection against these inflationary pressures may be appropriate. One option may be an all-weather strategy such as Ruffer Investment Company (RICA). The managers Hamish Baillie and Duncan MacInnes have built a portfolio that can be characterised as a simpler and cheaper hedge fund or absolute return strategy. They aim to grow investors’ capital over the long-term with a core focus on downside protection against the key risks managers see on the horizon – including their central case of a new regime of ‘persistent and malign inflationary pressures’. They take a balanced approach to portfolio construction which includes offsetting protective strategies such as index-linked bonds, credit protection, payer swaptions, gold exposure and equity put options along with allocations to attractively priced GDP- and inflation-sensitive equities. This has resulted in an annualised NAV total return of c. 5.6% over the past ten years and, more recently, a year-to-date NAV total return of c. 2.0% versus c. -10.8% generated by the ACWI with considerably lower volatility.

Capital Gearing Trust (CGT), managed by Peter Spiller, aims to preserve and, over time, grow shareholders’ real wealth. Its success and consistency can be demonstrated by Peter’s ability to generate positive shareholder returns for 39 out of the 40 years of his management. The management team believe long-term inflation expectations are too low, and more recently, the performance has benefitted from the team’s defensive approach and the shift into assets that exhibit consistent, and in some cases government-backed, cash flows such as European rental property and renewable infrastructure (c. 11% of portfolio), alongside short-duration index-linked bonds. The team has also been able to provide an element of shareholder value stability relative to NAV with the strict active management of the discount control policy. In light of this, the trust has performed particularly well in times of market stress, with a maximum drawdown over the past ten years of 4.8% compared to a fall of 21.4% in equities, as represented by the ACWI.

Alternatively, following a strategic review in Q4 2020, Aberdeen Diversified Income and Growth (ADIG) now provides investors with a source of diversification and uncorrelated returns to equites. The managers, Nalaka De Silva, Jennifer Mernagh and Nic Baddeley, have focused on allocating to private markets (c. 48% of the portfolio) and alternative investments that offer a degree of inflation-protection and uncorrelated cash flow generation through holdings in real assets such as infrastructure, real estate and royalties. In recent months this strategy has proven positive for risk-adjusted performance and has the highest dividend yield in the flexible investment sector of 5.8%. With the trust currently trading on a discount of -18.9% this may provide a good entry opportunity for investors.
 

 
_Disclaimer

_{This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.}