Lowland Investment Company — Is the tide turning?

By market capitalisation, the trust’s portfolio is typically split between larger, medium and smaller companies in equal parts, intended to optimise the balance between immediate income and income growth over time. The weighting towards larger companies is rarely above 50% but during the past approximately two years has been close to this level, until recently. At the end of March 2024, it was c 47%.

LWI’s largest exposure is still to the top 100 UK-listed companies but is well below the broad UK market weighting of more than 80% and has recently been reducing. Conversely, LWI’s investment in SME stocks is well ahead of the benchmark weight, and it is here where the managers identify the strongest opportunities.

LWI benchmarks its performance against the broad UK equity market index, although its clearly expressed and consistently applied strategy means that its weightings, by market cap, stock and sector, are inevitably and structurally very different. Performance divergence from the benchmark is to be expected over shorter periods, but the extent and duration of SME underperformance is notable, and this is reflected in the trust’s more recent returns.

LWI has a strong track record of long-term performance and outperformance of its benchmark. Over 25 years, its NAV total return is 635% compared with the broad equity market index return of 250%. However, taking the data to end February 2024, LWI’s NAV4 total return is behind the benchmark over one, three, five and 10 years.

Breaking the performance down into discrete years provides an insight into returns, in different market conditions, over the past 10 years. We note the tendency for LWI to outperform the benchmark when investor sentiment is positive and the broad market is rising strongly. This was very much the case in FY21, capturing the strong market rally, even more so in SME stocks, as the vaccine roll-out began and the economy emerged from lockdowns. In 2022, it was only the top 20 stocks in the broad UK equity market that collectively delivered positive performance.

The change in market dynamics in recent years is clear from a comparison of pre-Brexit performance versus the period since. In the five years ending FY15, in the run up to the Brexit vote in 2016, LWI delivered an NAV total return of c 101%, c 63% ahead of the benchmark. In the period since and up to end-FY23, LWI’s NAV total return is c 36%, c 30% behind the broad market.

Encouragingly, during FY23, LWI outperformed its benchmark by 3.4pp. Larger stocks continued to outperform during the year but by a lower margin than in FY22 and, although underweight in larger stocks, LWI outperformed in each market segment (large-, mid- and small-cap).

In the six months to 31 March 2024 (H124), mid-cap stocks have outperformed larger stocks, particularly in November and December 2023 as market expectations shifted towards a faster decline in interest rates. Small-cap stocks have performed broadly in line with the largest stocks in the same period. The sharp upward movement in both mid- and small-cap stocks in October and November demonstrates how quickly market conditions for SME stocks can turn.

That the UK market is low valued in absolute terms and relative to other global markets is not new, but the investment managers point out that a trailing P/E for the portfolio of 10.1x is substantially lower than its 10-year average of 13x, while the 12-month forward portfolio yield 5.2%. If that were not enough, they add that dividend cover is relatively high and earnings forecasting remains ‘cautious’. This is especially the case for domestically focused SME companies, where they see particular value.

There may be no immediate catalyst for a re-rating of the UK market and fund flows remain weak. Overseas investors have little enthusiasm for UK equities, UK pension funds have continued to reallocate away from equities and for many other UK institutional investors, SME equities have become too small and too illiquid, while UK funds continue to see negative outflows. This poses the risk of the market being a ‘value trap’ but, as investors wait, the relatively high yield supports returns and the low P/E should mitigate against adverse economic or global equity market corrections.

Although the valuation opportunity in SME companies has not as yet been widely recognised in the market, it has been reflected in much-increased takeover activity across the market and in LWI portfolio companies. The acquirers have been a mix of trade buyers and private equity investors.

The investment managers attribute the preponderance of transactions involving LWI investments to the types of companies they typically hold, generally established, well managed, cash-generative businesses, which display leadership in their own, sometimes niche, market segments. These are all elements that are likely to attract bidders of all types.

Notwithstanding the positive impact on the trust’s performance, these come with some regret on the part of the investment managers, as they believe that in many cases the prices paid do not recognise the full potential of the acquired companies.

In addition to the completed transactions shown below, it was reported in the press5 that the chemicals company Elementis had rejected an approach from a private equity firm, KPS Capital Partners, although this was not confirmed by either party.

In March 2024, Direct Line Insurance also received a conditional offer from Belgian insurer Ageas. Rejected by the Direct Line board, it has since been withdrawn. In a mix of cash and shares, at the time, the proposal would have valued Direct Line at 237p per share compared with 163p before the first proposal.

Many investor concerns, such as geopolitical tensions, are not specific to the UK, where the differentiating factor is perhaps the level of pessimism about the domestic economy. Having performed more robustly through 2023 than had been widely expected at the beginning of the year, GDP was nonetheless flat during the year and data for the final quarter of the year indicated that the economy ‘technically’ entered a recession, defined as two consecutive quarters of negative growth. The preliminary estimate for January 2024 is that GDP increased 0.2% in the month. It could be that activity is indeed softening in response to the significant rise in borrowing costs and cost of living pressures for consumers, but for now it is probably fair to say that the UK economy is continuing to flatline, as it has since early 2022.

Positively, a combination of higher wages and declining inflation is lifting consumers’ real disposable incomes, with the prospects of interest rate cuts to follow. This more favourable perspective would be consistent with the general picture that the investment managers are getting from their interaction with many companies and is the key reason why they see potential for a stronger UK economic development than is widely forecast.

The company has maintained or increased dividends each year since it was established in 1963 and aims to pay progressive dividends over time, with each quarterly distribution equal to or greater than the previous one. Over the 25 years to end FY23, DPS has growth by an average 6.8% pa. Progress was modest during the pandemic but the five-year average of 3.0% is above that of most of the trusts in LWI’s peer group and 10-year growth of 6.3% pa is close to the long-term average. During the pandemic and its aftermath, the trust was able to flex its revenue reserves to maintain the dividend policy and with dividend cover building, the rate of quarterly distribution was increased by 4.9% from Q323 (to 1.60p from 1.525p). The 6.40p annualised run rate of quarterly DPS compares with 6.25p for all of FY23 (3.05p in H1 and 3.20p in H2).

Encouragingly, the managers note that the corporate dividend payout in the UK market remains well below pre-pandemic levels and therefore should be more sustainable.

The portfolio managers, James Henderson and Laura Foll, are focused on long-term returns, with investment decisions driven by a selective, bottom-up approach with a strong valuation overlay. Henderson joined the industry in 1982 and the company in 1984, and Foll joined the industry and the company in 2009.

Using a range of valuation metrics, the managers seek to invest in companies that are trading at a discount valuation, in some cases compared with their trading history and in others compared with their peer group. There can be many reasons for a valuation discount, including disappointing recent financial performance, balance sheet or management concerns, and this alone is insufficient reason to invest. The managers want to see a route to recovery from whatever issues the company is facing, with the prospect of delivering sales, earnings and dividend growth, and their assessment of company leadership is one of the most important factors in making this judgement. They comment that a good management team can navigate a difficult economic backdrop, while poor management can get it wrong even in the good times.

As a result of the investment process, the portfolio managers engage with hundreds of companies every year. In doing this they are supported by the deep resources of JHI, where both are members of the JHI global equity team and work closely with the UK smaller and mid-sized company teams.

JHI has considerable resources, and long and broad-ranging experience in active equity management. It has c £150bn of equity assets under management, with investment and research capabilities across a wide range of strategies, sectors and styles. The investment team comprises more than 150 equity investment professionals, with an average of approximately 20 years’ financial industry experience, including specialist teams focusing on key sectors including healthcare, technology and energy. All JHI’s investment professionals, whatever their particular focus, combine insights gleaned from company meetings, to form the proprietary knowledge that enables them to generate the original, independent views that shape investment strategy across the company.

Portfolio diversification is a key element of risk management, primarily within the SME portion of the portfolio. At 28 February 2024, there were 114 holdings, within the trust’s expected 100–120 range. Eight of the top 10 holdings were top 100 companies, with a focus on higher-yielding financials and oil and gas producers. Also within the top 10 holdings were two Irish companies, non-life insurer FBD and maritime transport provider Irish Continental. In aggregate, the top 10 represented 23% of the portfolio, with the other 104 holding representing 77%.

The trust has the flexibility to invest up to 20% in non-UK stocks but in practice it is typically less than 5% and was 3.9% at the end of February, comprising the two Irish holdings. FBD, with a market cap of c £475m, has a leading market position within the Irish agricultural sector. The managers are attracted by its strong track record of disciplined underwriting, generating strong cash flow and dividends, including a special dividend in 2023. Irish Continental is Ireland’s leading maritime transport group, with a market cap of c £730m. It provides passenger, roll-on and roll-off freight services between Ireland and the UK. The managers note that it is a well-managed business operating in a duopolistic industry.

With stock selection being bottom up, sector weightings are substantially an output rather than a deliberate target. However, sector trading conditions and valuations will nonetheless have an impact on where the managers identify the best opportunities. Financials and industrials account for c 62% of the portfolio, around 27pp above the benchmark. The financials holdings are skewed towards large-cap banks and insurers, with the exception of FBD, whereas the industrials holdings have a larger exposure to a broad range of mid- and small-cap companies.

It is outside of the largest companies that the managers see the greatest current opportunities, particularly in domestically focused businesses and those where ‘self-help’ actions are improving prospects, yet to be appreciated by market. A number of new positions have been taken and existing holdings increased, in large part recycling capital released by takeover activity.

In February 2024, the managers established new positions in two retailers, Dunelm and Sainsbury’s. They note Dunelm’s ability to offer good-value products (across bedding and curtains, etc) while still having a single-digit market share and room for growth. The UK grocery market remains strong and larger operators such as Sainsbury’s have been winning market share. The company’s well-situated, large-format stores are well placed to benefit from the growth in omnichannel sales (combining in-store fulfilment with home delivery and click and collect).

Since the FY23 year-end in September, two UK property companies, Shaftesbury and Workspace, have been added to the portfolio. Workspace is a well-established business with a strong record of growth in providing flexible office space in and around London. Shaftesbury owns a portfolio of prime properties in London’s West End. In both cases, the shares were trading at a material discount to NAV, while operating trends (such as rental values) have remained encouraging.

A new position was also established in Beazley, which writes insurance across a range of end-markets and has been a leader in the development of cyber breach insurance. At the time of purchase, it was trading on a lower-than-average valuation with good prospects to return excess capital in the form of increased dividends or share buybacks.

Prior to its acquisition, the managers had been building a position in Wincanton, the third-party logistics company, with customers such as Kingfisher and Sainsbury’s. It had been trading at a material discount to its long-run averages, providing protection against cyclical risks and not recognising the potential upside from structural growth trends in its sector, and its ‘self-help’ investments in robotics and automation. Additionally, higher interest rates had opened up an interesting opportunity, reducing the value of pension fund liabilities and freeing up cash flow for planned investments, as well as shareholder distributions.

A new position was also established in defence contractor Babcock, which specialises in areas such as submarine maintenance. The managers note that under a new management team, the company has reduced its debt, taken out costs and migrated the business further towards contracts that allow for certain costs to be automatically passed through to the end-customer, providing greater margin certainty. In the same sector, and following good share price performance, the whole position in BAE Systems was sold on valuation grounds.

The managers have also identified opportunities to invest, at already reduced valuations, in companies that they believe have good long-term prospects but which have been negatively affected by shorter-term trading conditions or events, requiring additional capital to be raised. They participated in capital raisings by Videndum, a leading maker of hardware and software used in film, television and content creation, and XP Power, a leading manufacturer of power control solutions for the industrial technology, healthcare and semiconductor manufacturing sectors.

In recent months, existing positions have been increased in a range of companies including car distributor Inchcape, audio-visual equipment maker Midwich, crockery designer and manufacturer Churchill China, buildings material producer Marshalls and Scottish housebuilder Springfield.

The AIC’s UK Equity Income sector, of which LWI is a member, is one of the largest AIC peer groups and encompasses funds with a wide range of investment approaches within the overall remit of providing income and capital growth from a portfolio at least 80% made up of UK equities.

LWI’s multi-cap investment policy and significant exposure to mid- and small-cap stocks differentiates it from most peers. The Diverse Income Trust and abrdn Equity Income Trust are perhaps the closest comparators. We have also pointed to LWI’s greater exposure to domestic UK earnings and cyclicals, areas where it aims to identify attractive investment opportunities and which are more highly represented within the mid- and small-cap sectors.

As with the trust’s performance versus the chosen benchmark, long-term performance versus peers is also very strong. The trust is one of the strongest performers in the peer group over 20 years.

In the nearer term, LWI’s multi-cap investment policy and value-oriented approach has affected returns, which now feeds through to 10-year performance.

Costs are moderate and below the peer group average. Gearing is above the sector average and has recently increased as a reflection of the managers’ optimism. In part benefiting from gearing and an above-average discount to NAV (c 10% vs the peer average of c %),6 LWI’s dividend yield of 5.2% is among the highest in the peer group.

LWI’s managers view responsible investing as a long-term process that depends not just on businesses meeting current legislative standards, but also on operating with an understanding of changing societal attitudes towards issues such as climate change, pollution and working conditions. While ESG risks do not preclude ownership of a stock, they are a key consideration in arriving at an appropriate valuation and position size. Where evidence of poor practice emerges, the managers will engage with the company to discover how the problem is being addressed and will monitor progress to assess evidence of improvements. Specifically on governance, LWI always votes at the AGMs of investee companies, and the managers seek to work constructively with firms on appropriate executive remuneration structures to ensure the best alignment of the interests of management and shareholders.

Rather than relying on external ratings, which may be absent in the case of smaller companies or based on flawed, outdated or incomplete data, the managers review each new investment idea for potential ESG shortcomings. Any material issue they discover is discussed with JHI’s governance and sustainable investing team and/or the company itself before an investment is made.

A detailed description of the trust’s ESG policies can be found here.

Management fees are paid on a sliding scale, reducing as net assets increase and allowing investors to benefit from the growth in the size of the fund and economies of scale. Fees are calculated at a rate of 0.5% on the first £325m of net assets and 0.40% thereafter, split equally between the capital and revenue account. There is no performance fee. Ongoing charges for FY23 were 0.64% (FY22: 0.62%), which compares favourably with the AIC UK Equity Income sector’s simple average of 0.69% and is similar to the weighted average 0.58%.

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 board has set a limit of c 30% of the fund’s value at the point of drawing, although in practice gearing fluctuates at a level significantly below this. 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.

Net gearing as defined by the company7 was c 13% at end-February 2024 and 12.3% at end September 2023 (end FY23) compared with 12.5% year earlier.

The trust’s borrowings are a mix of long-term, fixed-rate notes and floating rate medium-term bank facilities. The £30m loan notes do not mature until 2037 and the 3.15% pa cost is highly attractive in current market conditions. The bank facilities, with BNP, allow LWI to draw up to £40m, priced at a lending margin of 0.9% plus the SONIA base lending rate, and mature in October 2025. The company has an option (conditional on lender approval) to increase the facility by £20m.

LWI is a conventional investment trust with a single share class and an unlimited life. There are 270.2m shares in issue and there has been no issuance nor repurchases during the past five years.

The top 10 shareholders account for c 60% of shares outstanding. Reflecting its strong retail following, within this, c 40% of shares are held on retail share-dealing platforms such as Interactive Investor, Hargreaves Lansdown, AJ Bell and Halifax Share Dealing. The other top 10 shareholders are mostly traditional wealth managers and 1607 Capital Partners, a US investor with a specialism in UK investment companies. In February 2022 a 10-for-one share split was implemented to increase the ease of trading and reinvestment of dividends for smaller holdings.

The value of shares traded over the past 12 months is £95m (c 30% of market cap) or an average c £370k per trading day, and has most recently increased.

Although the current c 13% discount to NAV is greater than the average of the past five (c 8%) and 10 years (c 6%), and wider than that of the peer group average (c 9%), given that this appears to be driven by current market conditions, with SME companies significantly out of favour, we would be surprised if the board were to change its current approach to discount management. It does not believe that a formal discount control mechanism is in the best interests of shareholders. It sees the use of share buybacks as negating some of the benefits of the closed-end structure, as well as potentially shrinking the size of the trust, reducing the audience of potential investors, increasing the ongoing charges ratio and reducing liquidity in the shares. In the board’s opinion, the best way to close or eliminate the discount is to provide attractive returns and to engage as broadly as possible with investors.

The board consists of six members who collectively bring a range of relevant experience including senior management in the public and private corporate world, investment management expertise and investment trust management.

As part of the trust’s succession planning, Robert Robertson, who has been chair since 2017, having joined the board in 2011, will step down at the 2025 AGM. LWI says it is expected that he will be replaced by one of the serving directors. Mr Robertson has brought extensive senior experience to the board, gained in a range of quoted and private companies including industrial and materials businesses globally as well as other investment companies.

As part of the overall planning process, Mark Lam was appointed to the board with effect from 1 January 2024. He has a strong understanding of technology, having formerly been chief technology and information officer for Openreach, the telecommunications infrastructure provider. He also has a good knowledge of governance, with many years of board-level commercial experience.

His fellow board members are Duncan Budge, 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, a chartered accountant who has worked at senior levels in the public and private sectors across a range of industries, and is a board member for three other investment companies; Thomas Walker, a chartered accountant and former fund manager with Martin Currie, who sits on the board of a further two investment trusts; and Helena Vinnicombe, with senior investment experience from Evelyn Partners (formerly Smith & Williamson), who is on the advisory board of M&G Charity Multi-Asset Fund and is chief investment officer for Child Health Research.