Lowland Investment Company — Multi-cap growth and income with focus on value

After a strong start to the year, the large-cap FTSE 100 fell back on the surprise announcement of a general election in the UK. A sharp rise in the value of sterling as markets factored in the possibility of a stronger Brexit negotiating position caused a decline in the share prices of the overseas earners that had driven the blue-chip index higher. Conversely, the more domestically focused mid-cap FTSE 250 index rallied on the news. As shown in Exhibit 2 below (left-hand chart), the FTSE 250 has significantly outperformed both the large- and smaller-cap indices over the past decade, albeit with a higher level of volatility, particularly following the UK’s EU referendum in June 2016. Notwithstanding this, from a valuation perspective (right-hand chart) the average P/E multiple (based on historic earnings) for the FTSE 100 index looks elevated compared with the FTSE 250 and FTSE Small-Cap indices. While the blue-chip index currently offers a much higher dividend yield, concerns have been voiced about concentration of dividends in a handful of stocks, in particular oil companies, where any further falls in the oil price could render payouts unsustainable. Given the heightened levels of uncertainty that are likely in both the short and medium-term, investors may prefer a fund with the flexibility to select stocks from all segments of the market, and the discipline to ensure it is not overpaying for growth.

Listed on the London Stock Exchange since 1963, the Lowland Investment Company (LWI) invests mainly in UK companies, with the aim of achieving above-average returns with growth in both capital and income. It has been managed since launch by Henderson Global Investors, with James Henderson as fund manager since 1990. In 2016, Laura Foll (who has worked alongside Henderson on the trust since 2013) was appointed joint manager. The managers take a value/recovery approach to investment, focusing on stocks whose quality and growth prospects appear under-appreciated by the market.

LWI uses the FTSE All-Share as a performance benchmark, but its portfolio – split roughly one-third each between large, mid-cap and smaller companies – differs significantly from the index, which is heavily weighted towards the largest companies. Portfolio construction is largely unconstrained, with a limit of 20% on overseas-listed holdings in order to comply with the AIC UK Equity Income sector requirements; in practice this allocation is used to access attractive business areas where no UK-listed equivalent is available. FTSE 100 holdings are not expected to make up more than 50% of the portfolio by value. While the trust is in the UK Equity Income sector, the managers have a total return approach and may take positions in companies that do not currently pay a dividend.

Henderson and Foll have recently been net buyers of stocks, finding value opportunities in more domestic and smaller companies, as well as some self-help situations in bigger stocks such as International Airlines Group and Royal Mail. The managers note that dividend yields on the kind of companies they have been buying are well in excess of the cost of borrowing, “and as long as we are confident that dividend growth is coming through, it would be wrong to be too bearish on equities”. Strong dividend growth in the portfolio has continued since the start of the year, with conservatively run, cash-generative companies such as Headlam, DFS and Shoe Zone declaring special dividends on top of ordinary dividend increases of between 4.1% and 8.7%. This contrasts with the picture for the FTSE All-Share index, where dividend growth has been slowing (currency benefits notwithstanding).

The trust’s remit to invest across the market cap spectrum has proved beneficial so far in FY17, with a performance boost from lower-yielding but faster-growing small- and mid-caps. With companies that show strong earnings momentum continuing to rerate, the managers have taken profits in stocks that have done particularly well, and reinvested in lower-rated but higher-yielding recovery situations.

From a macro perspective, LWI’s managers point out that with price inflation outstripping wage growth, there will be real pressure on consumers from the second half of this year. Rising prices are partly a result of the fall in sterling since the Brexit vote; however, there are some beneficiaries of the weaker pound in the portfolio, such as manufacturing and industrial companies that sell overseas. Further sterling weakness would boost the value of dollar dividends from some larger UK companies, and could also increase the attractiveness of British firms to overseas buyers, which could result in an increase in cross-border mergers and acquisitions. Should confidence in the UK economy wane during the Brexit negotiations and the snap general election campaign, the managers argue that LWI’s genuinely diverse portfolio should be an advantage.

LWI’s investment approach has remained essentially unchanged since its launch in 1963, seeking capital growth and a growing income from a recovery-focused portfolio of large, mid-cap and smaller companies. Four key tenets underpin the strategy: that the superior growth characteristics of small and mid-cap companies should make them better long-term investments; that a geared investment strategy is appropriate given that long-term equity returns have tended to exceed the cost of borrowing; that dividend growth goes hand-in-hand with capital growth as a driver of long-term performance; and that UK companies that are global leaders in their field have the potential to provide superior returns.

In order to uncover the best investment opportunities, Henderson and Foll undertake several hundred company meetings each year, as well as sharing information across the wider UK equity team at Henderson Global Investors. The managers filter the investment universe of c 1,500 companies using a range of valuation criteria, and aim to build a diversified portfolio of early-stage smaller companies, strongly growing mid-caps, big-name blue-chips and recovery stocks of all sizes. At the end of December 2016, one-third of holdings were constituents of the FTSE Small-Cap, FTSE Fledgling or AIM indices. These companies tend to be less well-covered by analysts, which means fund managers who do their own research can spot opportunities that may have been overlooked by the wider market. The managers say they only buy companies with real potential for sales and earnings growth, and prefer to invest when sentiment is poor, in order to maximise recovery potential.

Because the portfolio is diversified across 100+ companies, individual position sizes tend to be fairly modest, with most holdings outside the top 20 making up less than 1% of the total. New holdings generally enter the portfolio as 30bp positions and are built from there. The long stock list means the managers can make bold decisions in a small way, by backing companies that might be seen as too risky in a more concentrated portfolio. Rather than being a high-conviction process, LWI’s approach is based on the probability that a stock is cheap in relation to its growth potential. The gradual approach to building and divesting positions means the managers avoid the risks associated with trying to time the market. Just as the process hinges on slowly buying good stocks when they are cheap, the sell discipline centres on gradually disposing of holdings once they have reached valuations where further upside appears limited.

At 31 March 2017, LWI had 122 holdings, spread across FTSE 100, FTSE 250, FTSE Small-Cap and non-FTSE All-Share (FTSE Fledgling and AIM) stocks. The top 10 holdings made up 26.0% of the total, 2.6pp higher than a year previously. The vast majority of positions are below 1% of the portfolio, which the managers argue diversifies the income stream, as well as enabling them to invest selectively in riskier stocks with higher growth potential.

Much of the recent portfolio activity has centred on taking profits in stocks with earnings momentum that have done well and are now trading on extended valuation multiples. The proceeds from these sales, as well as from the increased level of gearing (up to 13% from 6% at the 30 September FY16 year-end), have been put to work in areas where the managers see value. Such positions include Henderson Opportunities Trust (also managed by James Henderson), which offers exposure to high- growth smaller companies and is trading at a discount to NAV; as well as larger companies like Royal Mail (sold at c £5 after the Brexit vote and bought back at c £4), which the managers say is attractively valued, and International Airlines Group, which could be better placed than peers in a post-Brexit world. Other new positions include insurance companies Randall & Quilter and Aviva and car dealer Marshall Motors, while the managers have also added to existing holdings in DFS and Shoe Zone. The latter three are all domestically focused, offering medium-term recovery potential but attractive valuations given the tougher period expected for the UK economy.

As shown in Exhibit 3, the largest absolute weighting is in financials, which has also shown the biggest increase over 12 months to 31 March 2017. As well as having relatively large positions in insurance and financial services, the managers have added to their holdings in banks over the past year, with HSBC and Standard Chartered both among the top 10 stocks. The managers continue to favour industrials, which make up the largest overweight versus the FTSE All-Share index (+15.9pp). The biggest reduction in exposure over the 12 months has been to basic materials, as positions in mining companies were reduced following a strong recovery in the sector.

LWI has a strong long-term performance record, producing annualised NAV and share price total returns of 12.8% since 1990 under manager James Henderson. Annualised total returns are also ahead of the benchmark FTSE All-Share index over five and 10 years (Exhibit 4, right-hand chart). Although absolute returns over the last 12 months were strong (left-hand chart), relative performance was affected by the mid- and small-cap sell-off in the wake of the UK’s EU referendum, and this has also had an impact on three-year performance versus the benchmark. However, over H117 (to 31 March), LWI outperformed the All-Share, with returns driven by small and mid-cap companies with earnings momentum, such as adhesives company Scapa, concrete specialist Somero, carpet firm Headlam, chain and gear manufacturer Renold and gas-to-liquid fuel company Velocys. Most of these positions were reduced into share price strength, with the managers adding to weaker performers such as 4D Pharma, where they felt share price falls were not justified by fundamentals.

At 25 April, LWI’s discount to cum-income NAV stood at 5.5%. This is in line with the one-year average but wider than the three-, five- and 10-year averages (3.1%, 2.0% and 3.7% respectively), although it has narrowed from c 9% earlier in the month. The discount reached a five-year high of 11.6% on 8 July 2016, shortly after the Brexit vote. LWI’s discount is currently wider than the 3.6% average for the UK Equity Income peer group and the 3.5% average for the AIC investment company universe, but with scope to narrow further should the positive performance trend be sustained.

LWI is a conventional investment trust, with 27.0m ordinary shares in issue. While the board has authority to buy back or allot shares to manage a discount or a premium, in practice the buyback power has not been used, and the most recent allotments were in December 2015. The trust may gear up to 29.9% of net assets, and has previously used short-term borrowing to achieve this. However, in order to lock in historically low long-term borrowing rates against a backdrop of higher inflation, in January 2017 LWI issued £30m of 20-year loan notes with a fixed coupon of 3.15%. There is also a three-year borrowing facility of up to £60m with Scotiabank. Net gearing stood at 13.0% at 31 March 2017, slightly below the approximately mid-teens long-term average.

Henderson Global Investors is paid an annual management fee of 0.5% of average net assets. A performance fee may be paid if LWI’s NAV total return performance is more than 10% above the total return on the FTSE All-Share index, subject to certain conditions (see our initiation note for a full explanation). For FY16, ongoing charges were 0.63% and no performance fee was paid.

LWI pays dividends quarterly, in April, July, October and January. The final dividend has tended to set the level for the first three interims of the following year. For FY16 LWI paid total dividends of 45.0p, fully covered by income. This was a rise of 9.8% on the previous year. Dividends have grown at a compound annual rate of 10.0% from FY11 to FY16, compared with 2.2% for RPI inflation over the same period. Over 25 years to 30 September 2016 the compound annual growth of dividends was 7.1%, compared with 2.7% for RPI inflation. Dividends have been maintained or increased for each of the last 40 years. A first interim dividend of 12p has been declared for FY17. Based on the 25 April share price of 1,500p and the last four declared dividends, LWI currently yields 3.1%.

The AIC UK Equity Income sector is one of the largest investment trust peer groups, with 23 constituents. Exhibit 8 below shows the 11 largest. Trusts in the sector follow a diverse range of strategies in terms of the size of companies they target and their investment style. Unsurprisingly, this leads to a wide dispersion of returns. Over one, five and 10 years, LWI’s NAV total returns are ahead of the weighted average for the peer group, ranking in the top quartile over five and 10 years and in first place over one year. Returns are somewhat below average over three years. Ongoing charges are below average, although LWI is one of only four trusts in the sector that may also levy a performance fee. The discount is wider than the average, gearing is slightly above average and, in line with its focus on capital and income growth, rather than a high starting yield, LWI’s 3.2% dividend yield is below the peer group average.

LWI has five non-executive directors. Robbie Robertson became chairman at the January 2017 AGM on the retirement of Peter Troughton; he has served on the board since May 2011. Karl Sternberg was appointed in January 2009, and Kevin Carter in October 2009. Duncan Budge became a director in July 2014. The newest director, Gaynor Coley, joined the board in November 2016 and is a qualified accountant who has worked as a director of the Eden Project and Kew Gardens. The other directors have backgrounds in industry and investment management.