Lowland Investment Company — A healthy recovery in portfolio income

LWI was established in 1963 and aims to achieve capital growth and a growing income for its shareholders by investing mainly in UK companies from across the market capitalisation spectrum. It is jointly managed by James Henderson (since 1990) and Laura Foll (since 2013) of Janus Henderson Investors (JHI), who are members of the global equity income team at JHI and co-manage Edison client Henderson Opportunities Trust (HOT) and the investment portfolio of the Law Debenture Corporation.

LWI is a member of the large Association of Investment Companies’ (AIC’s) UK Equity Income sector, which is comprised of 23 funds, and benchmarks its performance against a broad UK stock market index, although this is an imperfect comparator given the fund’s high weighting in mid- and small-cap companies, particularly those listed on AIM. The managers’ preference for out-of-favour value and recovery situations can also mean performance diverges from that of the index, which in a rising market naturally tends to be driven by the most popular stocks. The focus on small- and mid-sized companies arises because the managers believe that over time they are capable of growing their sales and earnings faster than their large-cap peers. As a group they are often overlooked by investors and analysts and so can be relatively misunderstood, mispriced or generally unknown, which provides opportunities for those investors willing to do the analytical work. However, LWI is not just about smaller companies; it is an all-cap fund and larger companies have an important role to play from an income, diversification and portfolio construction perspective. As a generalisation, larger companies, with their defensive, less volatile returns profile (when compared with smaller companies) and dividend track records, add an important element to the portfolio. Currently, 48% of the portfolio is invested in the largest 100 UK companies, which is historically quite high, with the remainder in small and mid caps, AIM and overseas (source: JHI, September 2022).

We discuss the investment process in more detail on page 11.

The International Monetary Fund forecasts global growth to decline from 3.2% in 2022 to 2.7% in 2023, while UK GDP growth in aggregate is expected to be only very modestly positive next year. In addition, investor sentiment remains adverse towards UK equities, which have seen substantial (US$18bn) outflows in 2022 (according to Bank of America utilising Emerging Portfolio Fund Research data), and even more so towards domestically focused small- and mid-sized companies, which have underperformed those with significant overseas earnings since the Brexit referendum in 2016. LWI’s bias to domestically focused earnings remains constant versus the index and peers (Exhibit 1).

The share price performances of the largest UK listed companies through 2022 have been significantly more robust versus small- and mid-sized companies due to the more defensive sector mix among the largest 100 companies, their higher exposure to overseas earnings and their perceived robustness in adverse economic conditions. That said, a lot of bad news is priced into stocks within the portfolio, which is trading on a historical P/E ratio of 8.7x versus the historical average of 12.7x and the broad UK market average of 9.6x (source JHI, 30 September 2022). The portfolio is also exhibiting significant value, sitting on a pronounced discount to the index in terms of price to cash flow, sales and book value multiples. Furthermore, LWI trades on a current discount to NAV of 7.5% versus its own 10-year historical average of -4.4%. There is currently value layered on value here.

At its heart the investment strategy seeks to identify underappreciated market leaders and given the mildly contrarian approach LWI has a long-standing and prominent weighting to cyclicals. This category includes a broad opportunity set in industries such as financials and industrials, where prospects are significantly affected by the direction and magnitude of economic growth.

Financials account for 33.4% of the fund versus 21.5% for the broad UK market and 20.5% (all at the end of November) for the Morningstar UK Equity Income category. The financials sector encompasses a variety of differing types of businesses, and the fund has positions in banks such as Standard Chartered and HSBC, insurers such as Phoenix Group and Direct Line, asset managers such as M&G, private client brokers such as Brooks Macdonald, consumer lenders such as H&T Group and brokers such as Numis. The drivers for these businesses are varied, such as rising interest rates steepening the yield curve allowing banks to boost margins by borrowing short and lending long, to the insurance premium cycle becoming firmer and regulatory changes increasing demands for discretionary portfolio management services. One of the newest portfolio positions in the financial sector is Conduit Holdings, which appealed to the managers as it is trading below tangible book value and at a substantial discount to peers. Due to the nature of catastrophe insurance, it is unforecastable, but the managers hope that the worst of the claims are behind Conduit and that insurance premiums are starting to harden, plus it provides an attractive yield of c 7%. The credit services holding H&T Group and gifting and experience company Appreciate Group have been among the strongest performers within the financials element of the portfolio in 2022, alongside Irish insurer FBD Holdings and Asian bank Standard Chartered. We discuss the performance of selected stocks in further detail on pages 6 and 7.

LWI has a significant weighting to the broad industrials sector. Industrials account for 23.6% of the fund versus 10.8% for the broad UK market and 12.2% (all at end of November) for the Morningstar UK Equity Income category. Industrials is a diverse sector, and the fund has holdings in aerospace and defence, with BAE particularly strong in 2022 (the size of the position has been trimmed on this strength), to building equipment, engineering and construction, including infrastructure plays such as Balfour Beatty. There are holdings in marine shipping, with Irish Continental Group being one of the largest portfolio positions, and industrial machinery (Morgan Advanced Materials is prominent position in this segment). Despite the sensitivity to economic growth and some aggressive share price de-rating within this broad cohort, LWI’s managers are not seeing much evidence of slowing end market demand for products and services and thus far order books appear resilient, with managements broadly confident in their ability to meet, if not exceed, expectations. This is a good example of where the managers seek to add value, using their experience and understanding of the individual businesses to judge where the market is being too indiscriminate and pessimistic on the outlook for these companies.

There is less exposure to consumer (both consumer discretionary and staples) within LWI than peers; in aggregate they account for 12.7% of the fund versus 26.5% for the broad UK market and 23.6% (all at end of November) for the Morningstar UK Equity Income category. The cost of living crisis has put some consumer stocks – especially those that are discretionary in nature – under severe pressure, which makes it an area deeply out of favour with investors. As a contrarian investor however, LWI does have some exposure via more defensive diversified consumer staples holdings such as Reckitt Benckiser, together with speciality retail via Halfords, food retail with Tesco and home improvement retail with Kingfisher. Positions initiated in 2022 include pork product supplier Cranswick and pension consultant XPS Pensions Group. The managers are keen to point out that not all consumer-facing companies will struggle operationally. For example, Halfords, which has seen its share price fall by c 44% in 2022 provides many goods and services that could be considered essential for those maintaining their car over the winter. It is precisely this disconnect between indiscriminate selling of consumer/retail stocks and the reality of the business drivers that appeals to the managers. There has also been some M&A within this area of the portfolio and Devro, which is a market leader in synthetic sausage casings, was acquired by a trade buyer for cash at an approximate premium of 60% to the undisturbed share price.

Purchases through 2022 have often focused on domestic earnings and Exhibit 1 illustrates the pronounced exposure that LWI has to UK earnings versus peers and the index. One very domestic earner added in later summer was Marshalls, which has seen substantial share price weakness through 2022, declining by nearly 60% as the cost of living crisis hit home improvement sales. Marshalls has been held in the fund previously and more recently it has moved into roof tiles and now has more diversified end markets in domestic, commercial and infrastructure. Other initiations include the UK pork supplier Cranswick and the managers also doubled down into the value on offer in existing holdings such as Johnson Service Group, Finsbury Food and Kingfisher.

The managers sold LWI’s long-held position in Centrica. The share price had performed strongly through 2022 in part due to rising wholesale gas prices. However, it was decided that due to the uncertainty around the price trajectory for gas, and the potential political and regulatory risk to business models, it was time to take profits in the position. Other sales included Bellway on concerns over buyer affordability in a rising interest rate environment and the cost of living crisis and Relx, following a period of outperformance.

LWI’s long-term (25-year) performance record is very strong with a NAV return of 572.1% versus the broad UK market return of 252.1%. However, the last 12 months have been more challenging (to the end of November 2022), with LWI returning a negative 1.3% in NAV terms (debt at fair value including income reinvested) versus the broad UK index return of 6.5% and the Morningstar UK Equity Income category return of 2.0%. Given the material exposure to UK mid and small caps, which posted respective negative returns of 13% and 27.5% over this period, LWI’s relative performance is arguably fairly robust. LWI’s share price return over this period was down 4.7% as the trust’s share price discount to NAV widened.

In general, the fund’s high relative allocation to smaller value type companies detracted as these performed weakly. As discussed previously, LWI has a value bias but despite value investing performing better in aggregate versus growth over the 12 months to the end of November 2022, it was not sufficient to counter weakness in both small- and mid-cap stocks, irrespective of style.

Looking specifically at the 12 months to the end of September 2022, which coincided with the company’s financial year, LWI’s NAV declined by 14.8% (debt at fair value including income reinvested) compared with the broad UK index return of negative 4% and the Morningstar UK Equity Income category return of negative 9.3%. Of the relative underperformance, c 40% was via the allocation to sectors and c 60% was due to stock selection. The portfolio’s overweight to the industrials sector was the principal detractor at the sector level, particularly in electronic components. The use of gearing also hurt relative returns albeit to a more modest degree. The slight overweight utilities position (multi utilities) was a moderately positive driver of relative returns at the sector level. It was also a difficult period for stock selection virtually across the board for the managers, but particularly in the consumer discretionary, industrials, financials and basic materials sectors.

The five largest positive contributors to the fund’s relative returns over this period were Serica Energy, FBD Holdings, Aviva and H&T. Not owning the Baillie Gifford-managed high growth Scottish Mortgage Investment Trust was also a top five contributor to relative returns.

AIM-listed Serica owns and operates North Sea gas fields and has benefited from rising energy prices over 2022, which has driven strong returns in its share price. Other energy holdings in the portfolio, such as i3 Energy, Shell and BP, have seen similarly strong returns. FBD Holdings is an Irish diversified insurer underwriting in the home, car, business and farming markets. It is a long-standing position for the portfolio and is gaining and retaining customers with robust underwriting profits. It has also retuned to paying ordinary dividends, now that its COVID-19 claims are settled. Aviva is another long-standing holding and an example of a larger company holding in the portfolio. It provides a high and growing dividend yield but trades at a lowly price to earnings/book value. It is well capitalised and is in the process of returning excess cash to investors and divesting non-core assets. H&T is the largest pawnbroker in the UK and specialises in secured lending largely against jewellery and watches, although it also offers foreign exchange and gold purchasing. It has performed well in 2022, meeting the needs for short-term, low value credit from customers, with the rising cost of living creating a tailwind for the business.

The five positions that detracted the most from LWI’s relative performance were its holdings in Studio Retail and Reach, not holding British American Tobacco and Glencore, and a below benchmark (3.8% average position versus the benchmark's 6.4%) weighting in Shell, which also detracted from the fund's returns relative to the benchmark.

Studio Retail was put into administration in February after it failed to secure sufficient funds to enable ongoing trading, brought on by increased shipping and transport costs, supply bottlenecks and delays. It was subsequently bought out of administration by Frasers Group. Reach, the online and media print group, which includes brands such as the Mirror, Daily Express and OK! was affected by the rising costs involved of physical printing and a still developing digital and data capability within what has been a generally weak period for advertising.

Since the end of the company’s financial year at the end of September, the portfolio has staged a decent recovery returning 8.3% to the 16 December which is 1.2% ahead of the broad UK market over this period. The discount also narrowed so investor share price total return is greater still. In this period UK mid-sized companies in general have performed well with particular strength in small and mid-sized value stocks. This illustrates how quickly Lowland’s performance can turn around when sentiment is supportive of the portfolio.

LWI sits within one of the largest, most high profile and most competitive AIC categories offering a range of differentiated strategies within an overall objective of investing in UK companies for capital growth and income. According to data provided by Morningstar, LWI’s portfolio has one of the lowest average market caps of the selected AIC peer group (Exhibit 9), which illustrates the deliberate multi-cap profile inherent within the portfolio (up to half may be invested in the largest 100 UK companies). LWI is also one of the most exposed within the peer group to UK domestic earnings, cyclicals and value stocks and has some of the lowest exposure to growth and defensive-style stocks. These portfolio statistics fit with the qualitative analysis of the investment process with Henderson and Foll seeking to construct a multi-cap portfolio of out-of-favour growth in capital and dividends companies.

As we have discussed, LWI’s performance had been affected by the multi cap and value characteristics inherent within the investment process. Over the longer term (20 years) the fund has delivered far better relative total returns versus peers (Exhibit 10), in part due to the managers’ multi cap approach. From a simplistic perspective, if investors are willing to accept more risk, they should capture this risk premia in returns. Other areas of comparative advantage include LWI’s fee structure, which is comfortably below the simple AIC average, despite its below average market cap versus peers. Some studies have concluded that low fees can be a powerful indicator of future returns. Lastly, LWI’s dividend yield is among the highest within the AIC cohort.

Looking at the last 10 years, and various timeframes, LWI has outperformed a select group of peers with value characteristics, but in the last 12 months its performance has been influenced by that of mid- and small-cap stocks in its portfolio rather than by its value bias.

LWI pays dividends quarterly (in April, July, October and January) and has a 47-year record of maintaining or growing its annual payout, with 2008 the only year in which dividends were held at the previous year’s level rather than increased since the trust was launched in 1963. Over the last 25 financial years including FY21, LWI’s dividend per share has increased by 6.9% annualised on a compound average growth rate.

LWI drew on its reserves in FY20 and FY21 to increase its dividend during the pandemic. However, the portfolio’s investment income has recovered strongly in FY22 to 6.10p per share from 4.27p the year previously. That said, portfolio revenues have yet to return to pre COVID-19 levels of 6.8p in FY19. At the end of FY21 17% of the portfolio was not paying a dividend, at the end of FY22 the figure is 5% and includes Oxford Science Enterprises and Ilika, which are not held in the expectation that they will pay a dividend, but rather for long-term capital growth. In addition, over the last 12 months LWI has received special dividends from NatWest and Castings. The UK dividend market itself has recovered since 2020, with special dividends being utilised in 2021 to make up for the deferments/cuts in 2020. According to data from Link, the trend in the market is upward, but still has some way to go before attaining the levels in 2019. The delisting of BHP from the UK market has affected the headline figure in 2022, but the weakness in sterling versus the US dollar in particular has been a tailwind for UK companies with overseas earnings, while UK mid cap dividend payouts grew quicker than the top 100 companies in 2022.

Foll explains that in general corporate dividend cover is high as debt levels are low and dividend payout ratios within the portfolio at 40% and across the market have not recovered fully. This has led to decent cash buffers, which will be useful in the event of a material economic slowdown or if the pace of negative earnings revisions picks up next year. In aggregate, LWI has a materially lower debt to capital ratio than the broader UK market and the Morningstar UK Equity Income category. With a current net dividend yield of 5.1%, LWI provides one of the highest yields in the AIC peer group. At the end of September 2022 dividend cover was 2.7x in the portfolio versus the broad UK market’s 2.2x.

At 20 December 2022, LWI’s shares traded at a 7.5% discount to cum-income NAV. This is a little wider than the medium-term average (7.7%, 6.8% and 6.6% respectively over one, three and five years). LWI’s board does not favour the use of share buybacks as a means of discount control, as it believes they negate some of the benefits of the closed-end structure and could potentially shrink the size of the trust, which in turn could reduce the audience of potential investors, increase the ongoing charges ratio and reduce liquidity in the shares. No shares have been repurchased in any of the last eight financial years (Exhibit 13), although the board may allot shares when the trust’s shares are trading at a premium to NAV, as seen during FY16.

LWI’s managers invest on a bottom-up basis with a keen awareness of valuations, seeking to create a diversified, multi-cap portfolio of c 100–120 mainly UK companiesOne of the key differentiators between LWI and most of its UK Equity Income peers is its high weighting in small- and mid-cap companies, which tend to average around two-thirds of the total portfolio through an investment cycle (although at end September 2022 there was a slight tilt towards larger-cap companies with 48% invested here). Across the classifications, Foll and Henderson are looking for well-managed, cash-generative, market-leading companies that are out of favour with the market. The six buckets ensure diversity in the portfolio, both in terms of company size and source of return, with some higher-growth names that can move up through the classifications over time alongside more traditional equity income stocks where most of the return may come from high and/or growing dividends.

The multi-cap nature of the portfolio, which may include a significant proportion in companies listed on AIM, means LWI’s profile (and hence its performance) is likely to differ appreciably from the benchmark, where c 80% of total market capitalisation is accounted for by the largest 100 names. Running a long stock list is a good way of limiting company specific risk, particularly in smaller firms that may be at a relatively early stage of development. The trust may invest up to 20% of its assets overseas; non-UK listed holdings currently account for c 10% of the total, with mostly Irish-listed companies with UK operations and a smattering of largely financial and resources companies listed in the Cayman Islands, Switzerland, Singapore and the United States.

Four key principles underpin the investment philosophy, which has remained largely unaltered since the trust was set up in 1963:

The managers use a range of valuation criteria to identify the companies in their investment universe of c 1,500 stocks that have potential to generate both capital appreciation and a growing income. They meet with hundreds of companies every year (virtually or in person), seeking businesses with real prospects of sales and earnings growth. Henderson and Foll strongly prefer to buy into companies that are trading at low valuations because their potential to recover and grow may be under-appreciated by the wider market. In addition, because they believe dividend growth is a key to long-term capital growth, the managers favour companies that pay sustainable dividends.

Henderson and Foll are keen to maximise the benefits of LWI’s investment trust structure, one of which is the ability to use gearing. The trust has a blend of fixed and flexible borrowing facilities, which allows the managers to make use of additional credit when there are sufficient opportunities. There is £90m of low-cost borrowing (c 25% of NAV) available, via a two-year bank loan of £40m (extendable to £60m) with Industrial and Commercial Bank of China at an interest rate of Libor+0.9%, and £30m of 20-year loan notes (maturing in 2037) with a fixed coupon of 3.15%. At the point of drawing down debt, it will never exceed 29.99% of the fund’s value. Gearing allows the fund to continue to be a net investor during periods of market volatility when the managers may not wish to sell other holdings. As income investors there is often an immediate ‘carry’ in using borrowings at relatively low rates of interest to invest into higher yielding assets.

LWI restructured its fee arrangements at the beginning of FY21, removing the performance fee and adjusting the tiers at which reducing management fees are paid to JHI. The manager is paid a fee of 0.5% on the first £325m of net assets (previously the first £375m), reducing to 0.40% thereafter (fees are split equally between the capital and revenue accounts). We like this approach as economies of scale are passed onto investors as the fund size increases and with net assets currently of c 347.5m (20 December), investors are benefiting from the cheapest marginal rate of fees. In FY22 fees were 0.6% (FY21: 0.6%) versus the AIC UK Equity Income simple average of 0.77%, which makes LWI the seventh lowest out of the 22 funds in the peer group.

LWI is a conventional investment trust with a single share class and an unlimited life. LWI’s market cap is currently £322.9m (20 December), which compares to the peer group average of £575m. However, within the peer group there are three trusts which are over £1bn each and if you were to exclude these then LWI is around average size. Overall, according to Morningstar data LWI has lower overall daily traded value than the average, although this is skewed by the larger trusts in the sector (Finsbury Growth & Income, Edinburgh Investment Trust and City of London).

In February 2022 a 10 for one share split was implemented to increase the ease of trading and reinvestment of dividends for smaller holdings. LWI has a strong retail following with c 37% of shares held on retail share dealing platforms such as Interactive Investor, Hargreaves Lansdown and Halifax Share Dealing. Traditional wealth managers are modestly represented in the top 10 investors and 1607 Capital Partners, a US investor with a specialism in UK investment companies is a relatively new entrant to the register.

The board numbers five with an average tenure of a little over six years and meets five times a year. Members collectively bring a range of relevant experience including senior management in the public and private corporate world, investment management expertise and investment trust management.

Chairman Robert Robinson has extensive senior experience in a range of quoted and private companies including industrial and materials companies globally as well as other investment companies. Duncan Budge is a former chief operating officer at RIT Capital Partners, a chairman of two investment companies and a non-executive director at a further three trusts. Gaynor Coley is a chartered accountant and has worked at senior levels in the public and private sectors across a range of industries. She sits on the board of three other investment companies. Thomas Walker is a chartered accountant and former fund manager with Martin Currie managing open and closed ended funds. He sits on the board of a further two investment trusts. Helena Vinnicombe is the most recent appointment. She brings senior investment experience from Evelyn Partners (formally Smith & Williamson) and is on the advisory board of M&G Charity Multi Asset Fund and is chief investment officer for Child Health Research.