Jupiter UK Growth Investment Trust — Update 15 June 2016

With all eyes on Britain’s referendum on EU membership on 23 June, UK stocks have struggled to advance in recent months, exacerbating a gap versus the rest of the world that has opened up over the past two years (Exhibit 2, left-hand chart). However, the UK stock market contains a multitude of companies with differing competitive dynamics, with some that would be boosted by the likely weakness of sterling should the ‘leave’ vote prevail, while others would benefit from maintaining the status quo, with a ‘relief rally’ possible across the board if (as widely expected by bookmakers, if not by the opinion polls) the vote is in favour of ‘remain’. Set against this are the wider economic and geopolitical worries that have weighed on world equities so far in 2016, and the fact that trading volumes are generally lower in the summer, which suggests that volatility may be higher in the
near term.

Meanwhile, valuations on larger UK companies (Exhibit 2, right-hand chart) arguably look less than compelling, with the FTSE 100 index on an average trailing P/E multiple of 23.9x at 31 May. What is important to remember here, however, is that an average does not paint the whole picture, and while the in-demand ‘bond proxies’ such as FTSE 100 consumer goods companies traded on an average 5.9x book value, the less-favoured financials in the blue-chip index were on 14.7x P/E and a price/book valuation of 0.9x at 31 May. This underlines the value of a selective and perhaps contrarian approach to identify stocks with the optimum combination of value and growth potential.

Jupiter UK Growth Investment Trust (JUKG) was formerly Jupiter Primadona Growth Trust (JPG, renamed Jupiter Global Trust between November 2015 to April 2016). Originally launched in 1972, in April 2016 it moved from a combination of UK equities and global funds to a concentrated, mainly UK equity portfolio that mirrors the £1.6bn Jupiter UK Growth unit trust. Both portfolios are managed by Steve Davies, fund management director and head of strategy for UK Growth at Jupiter Asset Management.

The trust invests in a concentrated portfolio of c 35 mainly large-cap stocks, chosen for their capital growth potential based on extensive analysis and modelling by the fund manager. Stocks are broadly split between those with secular growth potential (c 65%) and recovery situations (c 35%). It is a high conviction approach, leading to a portfolio that diverges significantly from the FTSE All-Share index benchmark. As a differentiator from the unit trust, JUKG may use gearing of up to 20% of net assets, and may also use derivatives. Both funds can hold up to 20% (currently less than 10%) in non-UK stocks. A zero-discount management policy was adopted by JPG in February 2014 and remains in place under the new strategy.

Manager Steve Davies outlines several bold decisions he has made for the Jupiter UK Growth unit trust portfolio, from initiating positions in overseas stocks in 2010, largely as a way of tapping into growth in emerging market consumers, to completely selling out of mining in 2011 after a research trip to China showed evidence of slowing infrastructure spending, and exiting his last oil holding in 2013 on the back of detailed supply and demand analysis. On an individual stock basis, he owns just one of the top 10 stocks in the FTSE 100 (Lloyds Banking Group), eschewing such household names as HSBC, Shell, BP, Vodafone, GlaxoSmithKline and AstraZeneca.

Davies’s former boss Ian McVeigh, lead manager of the Jupiter UK Growth fund until 2013, now heads Jupiter’s corporate governance function, which is an important input to the process. Davies says that governance concerns led him to avoid Tesco long before its operational problems came to light, while on the other hand, discussions with the CEO of Manchester United made him comfortable enough to take a position in the football club in spite of its majority ownership by the Glazer family. The manager has also engaged positively with ITV, encouraging the broadcaster not to go ahead with a rights issue in the depths of the financial crisis; Davies and McVeigh had seen early signs of recovery at the company, which remains in the UK growth portfolio today.

Davies casts his net widely in search of themes and stock ideas, drawing on sell-side analyst research and travelling extensively (including an annual trip to China). Sometimes ideas come from unusual sources: the manager first read about the trust’s one mining stock, Sirius Minerals, in a newspaper. While in the long term Davies is negative on the mining sector, Sirius is an atypical example: it owns a fertiliser mine under the North Yorkshire Moors, so is more geared to advances in food and farming than to how many new tier 4 cities are being built in China. Starting as an initial 0.5% position in the unit trust, Sirius is now c 2% in both the unit trust and investment trust, driven partly by further purchasing and partly by strong performance. Having secured planning permission in 2015, the company is likely to seek a further fundraising, in which JUKG would participate. Sirius is currently a small stock with a market cap of c £400m, but Davies says “there is a very big prize at the end” if it successfully reaches operation.

The manager views the JUKG strategy as eminently scalable given its high weighting (typically two-thirds to three-quarters) in FTSE 100 stocks. He describes the approach as one that aims to achieve mid-cap returns with large-cap liquidity. At present he sees the greatest capital appreciation potential from recovery stocks, although the average upside to two-year target prices across the portfolio is 60%, suggesting strong performance is possible if investment cases play out as forecast.

Davies’s background is as a sell-side analyst and he initially joined Jupiter as an analyst in 2007. As such, the manager sees detailed analysis of potential holdings and the competitive environment as fundamental to the JUKG investment process. This includes extensive field research in areas that might not seem immediately obvious for a UK equity fund manager, such as annual visits to China and a recent trip to a shale oil/gas producers’ conference in Texas, as well as staying in touch with the sell-side community as a potential source of ideas. While Davies is the sole manager on JUKG, the environment at Jupiter is collegiate and the manager is able to bounce ideas off team members, including global equity and bond managers as well as those in the UK equity team. Up to 20% of the portfolio may be held in overseas stocks.

JUKG’s portfolio is largely analogous with that of the Jupiter UK Growth unit trust, a concentrated fund with very low turnover (almost one-third of the 30-35 holdings have been in the portfolio at least since Davies joined the firm). At any one time he will have 10-12 companies on a reserve list for potential inclusion.

The portfolio is built from the bottom up, although Davies has a set of themes (see Current portfolio positioning) into which the majority of the stocks fit, and blends recovery and growth stocks, currently one-third and two-thirds of the portfolio respectively. The manager seeks capital growth from both types of stock, but has a distinct approach to assessing each type. Positions are sized based on conviction, with the top five holdings alone making up more than a quarter of the portfolio at 31 May.

With recovery stocks, Davies seeks situations where the potential reward outweighs the likely risk. Where a company has seen a sharp fall in profits and/or share price, the manager looks for a catalyst for recovery, such as a change in management or strategy, or an industry restructuring that takes capacity out of the market. (Dixons, still in the portfolio as Dixons Carphone, is an example of this, purchased for the unit trust in 2011 at a time when Davies saw the likelihood of main competitor Comet going into administration.) Cyclical recovery is another area of focus, with banks currently being the principal example.

With both recovery and growth stocks, valuation is a key factor. In the recovery ‘bucket’, potential holdings should have substantial price upside (at least 50% on a two-year view) and will normally have a forward P/E ratio of less than 10x at purchase, with a free cash flow yield of more than 10%. Financial stocks are usually valued on a price/book basis, with less than 1x P/B seen as potentially attractive. Davies models profit forecasts for all current and potential holdings, and looks for situations where there is substantial divergence between his projections and consensus forecasts.

For growth stocks, Davies runs a monthly screen to identify companies with at least 5-6% top-line sales growth, 7-10% profits growth and a free cash flow yield of 5% or more, leading to total annual shareholder returns of 12-15%. The screen might yield a list of 15-20 names, from which Davies will usually discard those that do not fit within a portfolio theme. Potential holdings in the growth ‘bucket’ should have long-term sustainable growth characteristics, and sufficiently predictable revenues for Davies to be able to build detailed financial models. He prefers to avoid areas such as business services (Capita, G4S and others) that are hard to forecast because of their reliance on external contracts. As with recovery stocks, valuation is important, and while growth stocks are unlikely to be trading on the sub-10x P/E multiples Davies seeks in the recovery area, he notes that it is possible to find sustainable growth on low-teens forward P/Es. An example is auto retailer Inchcape, bought on 12x P/E as a replacement for Burberry, sold on 20x P/E, with both stocks providing exposure to the Asian consumer. The above criteria narrow down the output from the screens to one or two companies per month that Davies deems worthy of further investigation.

For both types of stock, meeting management is a key part of assessing a potential investment, and Davies will usually meet with a company before undertaking detailed modelling work. With governance and sustainability forming a key part of Jupiter’s house style, Davies also meets with the chairmen and non-executive directors of investee companies at least once a year, a discipline he says gives him additional insights that he might not get from a CEO or finance director.

Every stock in the portfolio has a target price on a two-year view, worked out with a consistent methodology across stocks and sectors. When the share price reaches the target, Davies will make a further assessment and may revise the target higher if he sees continued growth, or exit the position completely. In selected cases, such as if there is potential for M&A activity, the manager may hold on to a position that might otherwise have been sold. Davies describes himself as a patient investor and will not necessarily sell a stock if it has not reached the target price within two years: an example is Lloyds Banking Group, where the manager’s recovery forecasts for the business proved accurate save for the longer-than-expected drain from PPI claims. However, where a recovery does not occur or growth does not materialise, Davies may exit a position, such as with Pearson, which was bought as a growth stock but came under pressure from providers of free education resources in the US, leading to earnings forecasts being missed.

In the unit trust, Davies has taken an active approach to managing cash as a means of risk reduction; the ability to gear up to 20% with JUKG gives him a further tool as a means of expressing market views. The investment trust also offers the ability to use derivatives, limited to 10% maximum exposure. Davies says he is likely to use this for specific alpha shorting opportunities, rather than for portfolio management purposes (other managers may write call options to boost portfolio income, or put options as a way of buying favoured stocks when prices fall). Shorting offers an extension to the high-conviction approach of JUKG, with the manager already being happy to have a zero weighting in big index sectors (oil and gas is a current example) where he sees the outlook as negative.

At 31 May 2016 there were 39 equity holdings in the JUKG portfolio. This is a much shorter stock list than the weighted average figure of 120 for the AIC’s UK All Companies sector; although this is skewed by the presence of a FTSE All-Share index tracker, even excluding this fund the weighted average is 87. The JUKG portfolio is also more concentrated in its top 10 holdings, which make up 45.7% of the portfolio, compared with a weighted average for the peer group of 33%.

Manager Steve Davies has a bias towards larger companies, which currently make up more than 60% of the portfolio, with most of the remainder in mid-cap stocks. Overseas stocks made up 8% of the total, split between the US (mainly Apple) and Germany (BMW and Adidas).

Industry weightings (Exhibit 3) are largely an output of the broad themes within which the manager selects stocks. The main recovery theme is UK banks, driving the largest single sector exposure. Lloyds, Barclays and Royal Bank of Scotland were all among the top 10 holdings at 31 May. The banks are recapitalised following the financial crisis yet remain unloved and very cheap, particularly Barclays and RBS, which are less far along the recovery path than Lloyds, and trade on price/book valuations of c 0.6x. While PPI mis-selling refunds have been a long-standing drag on balance sheets, the expected 2018 time bar on claims should provide a future boost to earnings.

Growth themes are split between cyclical and structural. The main cyclical theme is UK domestic stocks, which includes the aforementioned Inchcape and Dixons Carphone, as well as stocks geared to the housing market, such as housebuilder Taylor Wimpey, estate agent Countrywide and property portal Zoopla, builders’ merchant Howdens and furniture retailer DFS. The domestic theme has been present in the unit trust portfolio since 2012 and Davies says there will come a time when it begins to slow, although it could receive a boost if the UK votes to remain in the EU at the referendum on 23 June.

Global brands & travel is mainly a structural growth theme, driven in part by the growing middle class in emerging markets and the rapid growth in Chinese tourism. This theme supports the large overweight in travel and leisure: International Airlines Group, the owner of British Airways, is in the top 10, while Thomas Cook (bought as a recovery stock) is just outside. Merlin Entertainment, which operates Legoland and Madame Tussauds, is rapidly expanding into overseas locations, with theme parks due to open in Dubai, Japan and Korea over the next two years. Davies bought the stock when its valuation fell back following an accident at its Alton Towers theme park in 2015, in which several people were badly injured. Travel is also a theme underlying some of the overweight exposure to general retailers, with WHSmith a top 10 holding partly on the strength of its commanding position in UK airports.

The final main growth theme, ‘the connected world’, includes several stocks that also appear under other themes. More than simply a tech/telecom idea, the overarching theme is split into four sub-themes: devices, connection, content and data and e-commerce. Apple is central to the devices theme, with Dixons Carphone included as a leading handset retailer. TalkTalk is the largest exposure in the ‘connection’ theme, which includes mobile/satellite data and broadband providers fulfilling the appetite for connectivity. The content and data area features established media channels such as ITV and Sky alongside digital-first platforms such as Zoopla and credit scoring agency Experian, as well as Apple itself, which has recognised that in a market of increasing device penetration, in the future content is likely to be king. Also, there is a position in Manchester United, whose global fanbase (it has 69 million ‘likes’ on Facebook) would fill its Old Trafford stadium a thousand times over. The e-commerce area covers many stocks included under other themes, such as Lloyds, Dixons, Adidas and Thomas Cook.

Stocks may be included even if they do not fit within a theme; an example is Legal & General, which makes up the whole of the weighting in life insurance. Davies likes the company for its yield and dividend growth, a rare combination at the top end of the FTSE 100, where dividend cover is under pressure across a number of sectors.

A further manifestation of the high-conviction approach is the manager’s willingness to have little or nothing in certain sectors: currently the zero weightings in oil & gas and utilities, and very small exposures in healthcare and materials, add up to a c 25% underweight versus the FTSE All-Share. The avoidance of commodity stocks (with the exception of Sirius Minerals – see The manager’s view) is a theme in itself. Based partly on extensive conversations with US shale oil producers, Davies expects oil prices to be ‘lower for longer’, noting that the majority of these companies can survive with oil at $40 and would be able to ramp up production at $50. In contrast, he says that oil majors such as BP and Shell are priced for $60 oil, which has negative implications for their cash flows and dividends in the near term.

JUKG’s new investment mandate and benchmark means an analysis of historical performance is of limited relevance to assessing its future prospects. The exhibits below use a blended benchmark, made up of 75% FTSE All-Share and 25% FTSE World ex-UK until the new strategy was officially adopted on 18 April 2016 (with the portfolio rebalancing effective largely from that date), and 100% FTSE All-Share thereafter. The one-month and since inception figures in Exhibits 4 and 5 are the only ones that fully reflect the new approach, and it is encouraging to note that over this short period, JUKG’s NAV total return performance has been ahead of its benchmark, and also ahead of the FTSE World index. As shown in Exhibit 6, performance relative to the benchmark had been broadly positive but unremarkable under the old strategy over the past five years. With a concentrated portfolio that differs significantly from benchmark weightings, combined with the active use of gearing, the new JUKG strategy offers the potential to achieve more differentiated future performance versus the FTSE All-Share.

Exhibit 7 below shows the immediate impact of the zero-discount management policy introduced by JPG in February 2014, which has kept the shares trading largely in a range from a 2% discount to a 2% premium. The discount to cum-income NAV now averages 1.5% over one year, 2.7% over three years and 4.9% over five years. At 10 June, JUKG’s shares were trading at a 0.9% premium to cum-income NAV.

The board will buy back or issue shares to keep JUKG’s discount or premium close to zero. This commitment has been adhered to throughout the restructuring process, and since the proposal was published to transform JPG into JUKG, 728k shares have been bought back at a cost of £2.13m. In time, the board hopes that the broader appeal of the focused UK equity strategy will lead to natural demand for the shares, thus keeping the discount to a minimum without the need for a high level of repurchase activity.

JUKG is a conventional investment trust with one class of share. As Jupiter Primadona Growth Trust it underwent a five-for-one stock split in November 2013, and at 2 June 2016 there were 14.9m ordinary shares in issue. The nil-discount management policy adopted in February 2014 means the trust has been active in buying back its shares, with 5m shares repurchased under the policy to date. So far in FY16, 2.3m shares have been bought back at a cost of £6.8m. While the board remains committed to the nil-discount policy, one of the aims of the adoption of the new investment strategy is to make JUKG more attractive to a wider range of buyers; if successful in this regard then increased demand for the shares should naturally keep the share price closer to par.

The trust has a £10m borrowing facility with Scotiabank, £9.5m of which was drawn down at 31 May 2016, equating to gross gearing of 22%. The manager can deploy the gearing in a range of 10% net cash to 20% net geared. While Davies’s Jupiter UK Growth unit trust does not have the ability to gear, the manager takes an active approach to the use of cash, running with high levels of liquidity in times such as the onset of the global financial crisis in 2008, and the Arab Spring of 2011. The board of JUKG sees the ability to gear as well as to manage cash as a clear differentiator for the trust. However, in this transitional phase for the portfolio, there is currently a small net cash balance of 2.9% (as at 31 May).

Jupiter Unit Trust Managers (JUTM) is JUKG’s Alternative Investment Fund Manager (AIFM) under the AIFM Directive, with Jupiter Asset Management acting as investment adviser. Previously JUTM was paid an annual management fee of 0.8% of total assets for JPG, but this has been revised as part of the change to the new mandate. Under the new agreement, JUTM receives 0.5% of adjusted net assets up to £150m, reducing to 0.45% between £150m and £250m, and 0.4% thereafter. This is designed to make the trust more competitive with peers, both open and closed-ended. The performance fee arrangements have also been revised (previously 15% of outperformance of the composite benchmark, with a high water mark). A new 2% hurdle over the FTSE All-Share index total return has been put in place, above which JUKG may earn a performance fee of 15% of outperformance. The high water mark will also be reset to a level equivalent to JUKG’s NAV per share at the 30 June 2016 year-end. This will set an absolute floor below which no performance fee may be earned, and the intention is that it will be revised upwards each time a performance fee is paid.

Total fees (management plus performance fees) are now capped at 2% of year-end adjusted net assets in any financial year (previously 4.99%).

JUKG has historically (since FY14, previously twice yearly) paid quarterly dividends, and will continue to do so until the end of the current financial year (ending 30 June 2016). Dividends are paid in December, March, June and September and for FY15 amounted to 6.4p per share, a level the board has indicated is likely to be maintained for FY16. Based on the 10 June share price of 288.8p, this equates to a dividend yield of 2.2%.

Under the new strategy, JUKG will have more of a focus on capital growth, and it is the board’s intention that from the 2017 financial year (beginning on 1 July), there will be a single annual dividend. This is likely to be at a lower level; the board reports that the Jupiter UK Growth unit trust has a yield of 1.5% (based on its institutional income share class).

JUKG is a member of the Association of Investment Companies’ UK All Companies sector, having moved from the Global sector when it adopted its new investment approach. However, given the switch only occurred in April 2016, it is important to note that the majority of the performance data for JUKG in Exhibit 8 below reflects its old, global mandate. With this in mind, we have also included data for the Jupiter UK Growth unit trust, which is in most respects similar to JUKG under its new strategy, although again the comparison is imperfect because of JUKG’s ability to gear.

In performance terms, both JUKG and the unit trust are behind the weighted average NAV total return for the sector over one, three and five years. Because the largest trust (Mercantile) is a mid-cap and smaller company specialist, however, this has skewed the weighted average, given the strong performance of UK mid-caps in recent years. Jupiter UK Growth UT’s NAV total return is in line with the simple average over three years and well ahead of the five-year simple average of 45.5%. In terms of risk-adjusted performance as measured by the Sharpe ratio, the unit trust is behind the weighted average over one year but ahead over three years.

JUKG currently has an above-median dividend yield, although this is likely to fall to a level more in line with the unit trust. Thanks to the trust’s nil-discount management policy its discount is at the smaller end for the peer group. Because of a relatively high cash balance offsetting the 22% gross gearing, JUKG is effectively ungeared, a position it shares with half of its peers. Ongoing charges are somewhat above average but are set to fall following the cut in the base management fee (see above). Unusually, three-quarters of the trusts in the peer group levy a performance fee; JUKG is one of the 12 (out of 18) to do so.

JUKG has four independent non-executive directors; the board remains unchanged from that of Jupiter Global Trust and Jupiter Primadona Growth Trust. Chairman Tom Bartlam was appointed to the board in 2013. He is a co-founder and former managing director of Intermediate Capital Group, a specialist asset manager. Lorna Tilbian, the longest-serving director, joined the board in 2001. She is an executive director of institutional stockbroker and corporate advisory group Numis Corporation. Jonathan Davis, a financial journalist, writer and investment professional, became a director in 2011, while Graham Fuller, a former pension fund manager and a founding partner of PSigma Asset Management, was appointed in 2013.