Standard Life Equity Income Trust — Investment performance back on track

As shown in Exhibit 2 (left-hand side), over the last five years, the FTSE SmallCap and FTSE 250 indices have meaningfully outperformed the FTSE AIM 100 and FTSE 100 indices. After initially plunging, UK equities across the market cap spectrum performed strongly following the result of the UK’s EU referendum. Robust performance has continued into 2017, with UK indices hitting a series of new highs. Larger companies with overseas operations have seen their unhedged earnings boosted by the weakness in sterling, and UK economic data has been stronger than initial post-Brexit vote expectations, which has been supportive for companies with a more domestic focus. Considering valuations (Exhibit 2, right-hand side), on a P/E basis, smaller-cap equities, illustrated by the FTSE 250 and SmallCap indices, look relatively better value compared to the broader UK equity market. While small-cap stocks have lower average dividend yields than larger-cap stocks, data from Standard Life Investments suggests that smaller companies with forecast sustainable growth appear to have much higher dividend growth potential and better dividend cover than mega-cap companies. For investors seeking income from UK equities, a fund that invests across the market cap spectrum, with a good long-term performance track record, may be of some interest.

SLET was launched in 1991 and originally managed by Morgan Grenfell; since November 2005 it has been managed by Standard Life Investments (SLI). Thomas Moore has been sole manager of the trust since May 2012 (co-manager from November 2011), and aims to generate above-average income and real growth in capital and income from a portfolio of c 50-70 UK equities. The manager is unconstrained by FTSE All-Share benchmark weightings and SLET’s portfolio has a much higher weighting to mid and small-cap equities than the index. Risk controls state that at the time of investment, a maximum 10% of net assets may be in a single company and the top 10 holdings may not exceed 50%. SLET’s board has delegated gearing responsibility to the manager; a range of 5% net cash to 15% net gearing is permitted. At end-June 2017, net gearing was 11.6% (higher than the c 10% historical average).

The manager suggests that on a global basis, the consumer is in good shape. He believes that the economy is improving in the US and Europe, and while the UK consumer is suffering from higher CPI inflation as a result of sterling weakness, Moore expects this to peak relatively quickly. Given positive wage growth, he feels that UK consumers will start to feel more confident if inflation declines. Moore comments that improving UK employment trends and loose fiscal and monetary policy remain supportive for economic growth.

Moore believes that the UK stock market is now being driven more by company fundamentals rather than reacting to macro events, as in 2016. Given that he selects stocks on a bottom-up rather than a top-down basis, this environment is supporting SLET’s better relative performance. The trust is invested in companies across the capitalisation spectrum that have strong cash flow characteristics, giving them the ability to pay attractive and growing dividends. The manager notes that he is currently finding better investment opportunities in smaller rather than large caps: companies that are earlier in their life cycle, which have the potential to significantly increase their dividends over time, but are trading at reasonable valuations. He is also finding opportunities in consumer stocks, which are trading at abnormally wide discounts to the broader market as investors are extrapolating what Moore believes to be short-term negative currency trends.

Commenting on themes recurring in company meetings and recent earnings reports, the manager says that in general, within his universe, companies are in good shape and generating strong cash flow. He says that company managements have positive outlooks and he points to the strength in the UK construction sector, which investors may not have predicted given the outcome of the UK’s EU referendum.

Moore employs SLI’s Focus on Change investment policy. The thesis of this is that over the long term, stock prices are driven by company fundamentals; however, in shorter time periods, stock markets can behave less rationally, particularly when fundamentals are changing or have the potential to change. The belief is that different fundamental factors are the key drivers at different stages of the investment cycle. Stock-specific opportunities may include a change in industry competitive dynamics, a new product launch or a company restructuring or management change. The process ensures that the manager is style-agnostic, which offers the opportunity of outperforming the benchmark across the investment cycle.

Investment decisions are based on each of the following five considerations:

The manager is able to draw on the wide resources of SLI’s 60-strong equity team. The potential universe of c 1,500 stocks is initially screened using SLI’s proprietary stock-screening matrix. Stocks passing the screen are subject to in-depth fundamental analysis, including a focus on a company’s dividend and its corporate governance policy. The resulting portfolio of c 50-70 high-conviction positions has a focus on companies with strong cash flow and sustainable dividend growth; there is limited reliance on mega-caps and bond proxies.

At end-June 2017, portfolio exposure was split as follows: 39.5% FTSE 100, 38.1% FTSE 250, 10.3% FTSE SmallCap and 12.1% non-index (mainly AIM stocks). This compares to the broad splits of the benchmark FTSE All-Share of 80% FTSE 100, 15% FTSE 250 and 5% FTSE SmallCap.

The trust’s sector exposure is shown in Exhibit 3. Over the last 12 months there has been a meaningful reduction in consumer services and telecom exposure, where SLET is now underweight versus the index, following the sale of BT and the partial sale of Vodafone. Apart from telecoms, portfolio exposure is broadly similar to six months ago, with overweight exposures in financials, industrials, consumer services, and technology (which has a very modest representation in the index). SLET remains significantly underweight the oil and gas sector and, illustrative of the unconstrained investment approach, the fund retains zero exposure to the healthcare sector, which is a meaningful weighting in the index, as the manager is unexcited about industry fundamentals.

A key feature of portfolio activity over the last six months is higher exposure to companies that have the potential to increase their dividends. The manager highlights some recent smaller-cap purchases in the portfolio: Ashmore, GVC, River and Mercantile and Tyman. Ashmore is an emerging market asset manager. This asset class had been out of favour for a long time due to weakness in emerging market economies. However, now that the economic environment is improving, helped by firmer commodity prices, Ashmore is starting to see inflows, albeit well below its historical run rate. The manager suggests that inflows could return to historical levels, which would allow the company to leverage its fixed cost base, leading to much higher levels of profitability. He expects Ashmore to increase its dividend, which has not risen since 2015 (its current dividend yield is 4.7%). Moore has very high conviction in this position; he suggests that now Ashmore’s business cycle is turning, its stock could be a “multi-year winner”.

GVC is a sports betting and gaming company. Dividend payments resumed in early 2017, having ceased since 2015 due to the acquisition of bwin.party. GVC is a leading provider of both business-to-consumer (B2C) and business-to-business (B2B) solutions, offering a wide range of sports and gaming products in an industry that has structural growth. The company generates high levels of cash flow and, despite strong share price appreciation, the manager feels that its valuation remains attractive, with a free cash flow yield of c 10%. Moore says that there is potential for the company to increase its dividend, while continuing to invest in the business (its current dividend yield is 3.3%). GVC has an ambitious management team and key executives have a large part of their personal wealth in the company. They would consider it a failure if annual revenues grew at less than a double-digit rate. The manager suggests that the company is not that well researched by the investment community and also not widely held by income investors, despite having an above-average dividend yield.

River and Mercantile is a financial services company with a high dividend distribution policy (its estimated dividend yield is 4.0%). It is an asset manager and service provider, whose key product is P-Solve, a liability driven investment solution across multiple asset classes, which is in high demand from clients wishing to de-risk their own balance sheets.

Tyman provides engineered components to the door and window industry. It is a high-growth company; revenues have compounded at an average annual rate of c 16% over the last five years both organically and as a result of acquisitions. The industry is fragmented, so the company is acquiring to cement its market leading position. Operations in a variety of geographies (more than 80% of earnings before interest and tax are generated outside of the UK) mean that Tyman’s cyclicality is somewhat reduced, as weakness in a particular region can be offset by strength elsewhere. Over the last five years, the company’s dividend has compounded at an annual rate of c 25%; its current dividend yield is 2.9%.

SLET’s relative performance in 2016 was meaningfully affected by the outperformance of large-cap companies with overseas earnings, which performed significantly better than small and mid-cap companies with more domestic operations both before and after the UK’s EU referendum. However, SLET’s performance is now back on track. Over the last 12 months, its NAV and share price total return of 19.0% and 17.0% are ahead of the benchmark’s 14.9% total return.

SLET’s relative returns are shown in Exhibit 5. Its NAV total return has outperformed the FTSE All-Share over all periods shown and its share price is ahead over all periods except three months.

SLET’s share price discount to cum-income NAV has narrowed meaningfully from the three-year low of 11.3% on 3 November 2016, which was a period of heightened investor risk aversion ahead of the US presidential election. Its current 5.4% discount is narrower than the 6.4% average discount of the last 12 months, but modestly wider than its average discounts of 3.4%, 2.9% and 4.1% over the last three, five and 10 years respectively.

Following the final exercise date and subsequent suspension of listing of SLET’s subscription shares, the trust now has one class of share; there are currently 49.2m ordinary shares in issue. SLET has a £30m bank lending facility with Scotiabank. During H117, the average cost of borrowing equated to an annualised rate of 1.12%. At end-June 2017, net gearing was 11.6%.

Standard Life Investments is paid an annual management fee of 0.65% of total assets up to £250m and 0.55% on assets above £250m (prior to October 2016, it was 0.65% of total assets); this is charged 30% to revenue and 70% to capital. In FY16, ongoing charges were 0.96%, which was 2bp higher than in FY15.

SLET pays quarterly dividends in March, June, September/October and December/January. In FY16, the annual dividend of 15.4p was 4.8% higher than in FY15; over the last five years, the annual dividend has compounded an average rate of 4.4% pa.

So far in FY17, SLET has paid a first and second interim dividend of 3.8p each, which were c 12% higher than the 3.4p first and second interim dividends in FY16. The board has announced its intention to pay a third interim dividend of 4.0p followed by a final dividend of at least 5.2p. This would equate to an annual dividend of at least 16.80p, which would be a 9.1% increase versus FY16. Based on the current share price, SLET’s dividend yield is 3.5% (prospective yield of 3.7%).

SLET is a member of the AIC UK Equity Income sector, a relatively large group of 23 peers. In Exhibit 8, we show the largest 16 trusts, which have market caps in excess of £175m. SLET’s NAV total returns are ahead of the whole sector weighted average over one and five years, ranking seventh and fifth, respectively out of 23 funds, while lagging over three and 10 years. Over one year, SLET is 4.9pp ahead of the weighted average. It should be noted that compared to when our last note was published in late-January 2017, SLET’s performance versus its peers has improved across all periods shown. The trust trades on a broadly average discount, has a higher-than-average ongoing charge, but no performance fee is payable. SLET has a higher-than-average level of gearing and a modestly higher-than-average dividend yield.

There are five directors on the board of SLET; all are non-executive and independent of the manager. Chairman Richard Burns was appointed in 2006 and assumed his current role in December 2014. The other directors and their years of appointment are Josephine Dixon (2011), Mark White (2013), Jeremy Tigue (2014) and Caroline Hitch (2017).