Securities Trust of Scotland — Compounding over time

With the developed world experiencing rising inflation and questioning whether it will be long lasting, Harries and Boniek have stayed calm. Whether or not inflation persists, the managers are confident that STS’s portfolio remains well positioned to deliver high single-digit to low double-digit total shareholder returns consistently throughout the cycle.

Harries explains that in the scenario of rising inflation, he believes interest rates will remain low due to high levels of government debt across developed economies. This would lead to low real interest rates and hence lower returns from high-risk assets, particularly growth equities. Noting that STS’s TR consists of both income and growth elements, compounded over time, he believes that in this scenario the trust will be able to outperform the market over the short and medium terms. He compares STS to an index-linked bond and explains that in an inflationary scenario, such instruments will deliver rising and compounding returns.

The manager highlights that inflationary effects might equally be temporary. Technological disruption, coupled with an ageing population, is likely to continue putting downward pressure on global demand, helping to stem inflation. The manager believes that STS’s portfolio companies will also do well in a low interest rate and low inflation environment. Consistent and relatively high income, hard to come in this environment, will continue to flow from investees, explains Harries.

The managers also believe that in the long run, companies’ sustainable cash flows and business growth will have much more of an impact on shareholder returns than either economic policies or politics. They continue to monitor the investible universe, typically consisting of companies with high resistance to macroeconomic and political shocks, such as those caused by the COVID-19 pandemic.

At 30 September 2021, the portfolio had 34 holdings (33 holdings at 31 December 2020). Exhibits 1 and 2 show STS’s portfolio by sector and geography, respectively as at end-September 2021.

Exhibit 1 illustrates that the portfolio continues to be focused on seven sectors – those deemed by the team to have a quality bias, with the top three being consumer staples (41.4%), information technology (19.2%) and healthcare (17.2%), similar to the portfolio at end-November 2020 of 42.0%, 18.4% and 19.5%, respectively.

Geographically, STS’s portfolio has stocks in developed markets at its core (Exhibit 2), with the highest exposure to the US (54%) and Europe (including the UK: 42%). Asia Pacific ex-Japan and Japan each represent 2% of the portfolio.

Since their appointment on 12 November 2020 and restructuring the portfolio the following month (please see our initiation note for details about portfolio restructuring), Troy AM’s managers have made some changes to the portfolio.

In December 2020, the team initiated a position in Fastenal (FAST US), a distributor of industrial products in the US (originally nuts and bolts, or fasteners, as they are known in the US). The managers chose it for its relatively high, consistent and dependable return on capital employed. The company achieves this high return by benefiting from economies of scale and dense distribution networks. Fastenal adopts quickly to change and provided PPE for the management of COVID-19. The company is upgrading its position in the value chain from distributor to supply chain provider.

In April 2021, the team initiated a position in Nintendo (7974 JT), the renowned Japanese developer and manufacturer of video games for indoor use. Its gaming franchises include Mario, Zelda and Pokémon. Troy believes the business is becoming more valuable, as more people experience and interact with its games. It also develops new products, including Nintendo Switch, launched four years ago. The managers believe that this development is on track to become one of the most successful consoles of all time. The team believes that a c 18x forward P/E multiple and a 3% dividend yield do not reflect Nintendo’s potential or the vast intellectual property (IP) bank within the corporation, but consider it attractively valued.

The team also bought an equity stake in Chicago Mercantile Exchange (CME), perceived by the fund managers to be a structural beneficiary in the use of futures and options.

Exhibit 3 presents the top 10 holdings in STS’s portfolio. The portfolio retains a defensive consumer staples and healthcare tilt, with some technology and, given the buy-and-hold long-term strategy, the changes to the top 10 since the managers took over STS’s management have been relatively small. Seven of the top 10 holdings were in the portfolio in November 2020. The largest weighting change (0.9pp) was in Unilever, as its share price suffered during the COVID-19 pandemic. The team retains high conviction in the stock and it continues to feature in the top 10 holdings.

The team switched Verizon Communications (VZ US), the holding inherited from the previous manager Martin Currie, into Boston Properties (BXP US) – a high-quality owner of A-grade properties in the US. The managers believe the company is discounted by the market due to concerns that office space will be used less frequently, following the pandemic and the widespread shift to remote working. Troy believes that prime US locations (on the coasts and in capital cities, where BXP’s properties are) will still be in high demand.

FAST’s purchase was funded by the sale in Emerson Electric (EMR US), as the team believed FAST was a better match for the portfolio. Other exits included IG Group (IGG LN), the UK’s leading spread betting platform, with a dominant market share and tight dealing spreads leading to competitive advantage. After the investee’s management team allocated capital, part-funded by equity and without seeking shareholder approval, rather than using the funds to pay special dividends, Troy exited the stock in February 2021.

The trust is geared by approximately 7% (at 31 October 2021).

The managers strive to optimise the combination of value, quality and growth. In many sectors, particularly in the tobacco sector, returns are attractive and STS’s top 10 portfolio holdings include world-leading tobacco companies Philip Morris International and British American Tobacco. To navigate and address ethical factors, Troy makes a distinction between ethical funds and ESG restrictions. Having no ethical restrictions, STS’s portfolio seeks an optimum combination of holdings that have the potential to produce the best risk-adjusted return.

STS’s former manager, Mark Whitehead, was appointed in May 2016 and adopted the trust’s current mandate on 1 June 2016 until Troy’s James Harries took over in September 2020. Therefore, the most relevant performance figures to consider for the current manager are over one year and shorter periods.

We have also included the performance track record of the current fund manager, Harries, who assumed responsibility for STS on 12 November 2020. We highlight the Trojan Global Income fund, which was established in 2016 and has been managed by Harries since he assumed responsibility. Considering that the Trojan Global Income fund is an open-ended vehicle and does not employ gearing, its performance has been very robust. Exhibit 5 illustrates that STS’s NAV outperformed the Trojan Global Income fund on a total return basis over one year by 0.4%, as it uses gearing, and we expect the closed-ended vehicle to outperform its open-ended sister fund with the same strategy during the rising equity market over a measured period. STS’s portfolio is almost identical to Trojan Global Income Fund’s, with the exception of two holdings: Domino’s Pizza (not in STS) and Fever-Tree (only in STS).

Exhibit 6 shows the AIC Global Equity Income sector, which consists of six funds. The open-ended peer group comprises 60 funds and we show their averages for comparative purposes. STS remains one of the smallest funds among its peers, ranking fifth by fund size. The trust’s performance from June 2016 to the end of November 2020 was principally down to Whitehead, Martin Currie’s manager. The most relevant NAV total return performance periods to consider are one year and shorter periods. While STS lagged closed-ended peers over one year, with a NAV TR of 13% versus19.3%, it has outperformed the peer group over the past six months (7.0% versus the 6.1% peer average, see Exhibit 6).

We have also shown the performance of the new fund manager, Harries, using his Trojan Global Income fund (STS’s strategy). Its total return is competitive. Exhibit 6 also illustrates that the Trojan Global Income Fund’s risk-adjusted returns over three and five years are superior to the open-ended peer average. STS’s strategy performed very close to the average of 60 open-ended funds over three- and five-year periods in absolute terms, but with lower volatility.

STS’s ongoing charge of 0.9% is closer to the high end of the group; but the new fee structure is likely to produce a lower charge going forward. There is no performance fee. The trust trades at a small discount to cum-fair NAV, ranking third on the date shown. The newly introduced discount control mechanism is likely to keep the share price at around the NAV level. STS ranks fourth on gearing and fifth in terms of dividend yield (2.6%).

STS is currently trading at a 1.6% discount to cum-income NAV. As shown in Exhibit 7, the trust has consistently traded around NAV. The average discounts over the past one and three years are 1.3% and 2.3%, respectively. The discount has been widening from June 2020 following the news that former Martin Currie manager, Mark Whitehead, had resigned, to September 2020, when the market received the announcement about Troy AM’s appointment positively (see our initiation note for details). Between mid-September 2020 and start of October 2021, the discount has narrowed significantly and since then to date it has been trading around NAV.

At the time of the handover to Troy AM from Martin Currie in Q420 (see our initiation note for details), STS’s board introduced a discount control mechanism aimed at maintaining the share price at around NAV. It has the authority (renewable annually) to repurchase up to 14.99% of issued capital and to allot up to 5% to help manage supply and demand for STS shares. During FY21, STS bought back 2.9m shares for a total cost of £6.0m (FY20: 0.4m at a cost of £0.8m). During FY22 to end-November, it repurchased 2.5m shares for a total consideration of £5.1m.

The board also intends to sustain the marketing initiatives to promote the trust.

The investment philosophy of STS’s management team is to find good-quality companies that offer both capital growth and an attractive dividend yield over the long term. The board reset the dividend for FY21 to 31 March to a level of at least 5.5p per share, which was deemed to be more sustainable, and the company distributed 5.7p per share (6.41p per share paid in FY20). Dividends are paid quarterly.

On 6 October 2021, the company announced its first interim dividend for FY22 to 31 March of 1.375p per share (1.375p per share for the corresponding quarter in FY21). While the board has not yet provided a target for the FY22 dividend, it anticipates steady growth in dividends from the revised level, thus employing a progressive dividend policy.