BlackRock Sustainable American Income Trust — Positioned for economic weakness

DeSpirito, Zhao and Yang believe that the odds of a US recession have increased since the Federal Reserve started raising interest rates. The managers explain that the economic impacts of higher rates tend to occur within six to 24 months, so we are starting to see the effects of the first 25bp hike in March 2022. This also coincides with the lack of COVID-19-related fiscal support and higher inflation, meaning consumer demand is starting to weaken. While the Federal Reserve has indicated that it will continue to tighten monetary policy in a bid to bring inflation under control, how long this will last is unknown. The managers suggest an ideal outcome would be a soft economic landing, but this is incredibly difficult to achieve, and they say that the last successful soft landing was 20–30 years ago. While US inflation is starting to roll over, DeSpirito, Zhao and Yang say it is not happening fast enough – for example, energy, shipping and food costs remain elevated – hence, the odds of a recession are increasing.

The managers highlight that from an earnings perspective, there have been an increasing number of below-consensus announcements across a range of industries including FedEx Corporation (transportation – its shares fell by more than 20% on the news), Carnival Corp (cruise lines), CarMax (used car retailer), Tesla (autos and clean energy), Nike (sports apparel), VF Corporation (apparel) and Ford Motor Company. Moving through Q422, they expect companies to guide down their earnings outlooks more aggressively. DeSpirito, Zhao and Yang comment that a silver lining could be if the Federal Reserve steps back from raising interest rates, which would likely lead to a stock market rally, but they are not willing to make that call. The managers are looking to take advantage of market opportunities but consider that stock prices are not yet washed out enough and they expect market volatility to continue.

DeSpirito, Zhao and Yang reiterate that we are starting to see higher interest rates take hold in the economy. Breaking the consumer down into five quintiles (one being the highest and five the lowest), they explain that until recently, there was pressure at the lower end (quintiles three to five) but now the impact is being felt in the higher cohorts. The managers comment that New York apartment sales have declined by 18%, indicating that economic weakness is trending up the chain, and note that since the beginning of 2022, 30-year mortgage rates have increased from c 3% to c 7%, and the last time they were this high was in Q101. DeSpirito, Zhao and Yang say this will take its toll on the economy with average monthly mortgage payments rising by hundreds of dollars. They expect a range of real estate pockets to roll over as there was increased demand for property in secondary markets due to people working at home during the pandemic.

The managers say that the consensus view is that there are now more things to worry about regarding the economy than at the beginning of 2022, and in such an environment, it is important to ensure that there is as much resilience as possible built into BRSA’s portfolio as recession risk is higher. They comment that they are laser focused on company balance sheet quality and are undertaking recession analysis by modelling an economic downturn two-thirds as severe as during the global financial crisis to determine the potential financial impact on investee companies. DeSpirito, Zhao and Yang say it will be too late to conservatively position the portfolio if they wait for a recession, and conversely, it will be too late to position the fund more aggressively when there is clear evidence of an economic recovery. According to the managers, a potential outcome is that by mid- to end-2023, the Federal Reserve will start to acknowledge that its work is done, and monetary policy can ease. However, they suggest that it is likely that the central bank will overshoot in terms of raising interest rates. At which stage it will try to boost the economy by increasing the employment rate, but this is a delicate balancing act and has not been achieved before; hence, a soft landing looks unlikely.

Looking at the US stock market, DeSpirito, Zhao and Yang say the valuation of growth stocks has normalised. They explain that the highest quintile of growth stocks versus the market had two peaks: in the dot-com boom and during the COVID-19 pandemic, and now that valuations have normalised there are some very attractive opportunities in growth stocks. The managers are unsure why quality stocks are generally out of favour, suggesting they should not be so reasonably priced given the uncertain economic environment. DeSpirito, Zhao and Yang are focusing on companies with economic moats, strong balance sheets, robust cash flows and well-regarded management teams. They report that these stocks remain inexpensive versus the broader market.

At the end of September 2022, BRSA’s largest 10 holdings made up 28.0% of the portfolio, which was a lower concentration compared with 31.3% 12 months earlier; five positions were common to both periods. Around 18% is held in non-North American listed companies.

As shown in Exhibit 3, over the 12 months to end-August 2022, the largest changes in BRSA’s geographic exposure were higher weightings in the UK (+4.6pp) and the US (+2.9pp) and lower weightings in Canada (-2.9pp) and Norway (-1.9pp).

Over the 12 months to end-September 2022, there were higher weightings in energy (+4.1pp) and healthcare (+2.6pp), and lower weightings in financials (-2.9pp), communication services (-1.9pp) and utilities (-1.6pp).

The trust’s largest overweight exposure at end-September 2022 was technology (+5.7pp). Companies held are well-established names with strong balance sheets and cash flow generation with products that are heavily embedded in the corporate world, such as Cisco Systems, Microsoft Corporation and Oracle Corporation. DeSpirito, Zhao and Yang say that these firms’ growth profiles hold up relatively well during periods of economic weakness given their recurring revenue streams and strong management teams. BRSA is also overweight healthcare stocks (+3.9pp) as the managers prefer this sector to other defensive areas of the market. They explain that consumer staple and utility stocks are trading at an average 20% premium to the market, as there is a general perception of safety, so these names have been bid up by investors, whereas, on average, healthcare stocks are trading at a discount. Fundamentals within this sector are favourable supported by global demographic trends. There had been pressure on medtech stocks during COVID-19 as their products are widely used in elective procedures, but now volumes are rebounding.

BRSA remains overweight the financials sector (+2.2pp), although exposure has been reduced. The emphasis is on high-quality money-center banks, which have a range of businesses including wealth management, trading and investment banking. Their net interest margins are increasing in the rising interest rate environment as loans are repriced faster than deposits. In the past, bank credit losses have tended to spike during a recession, but now their Tier 1 capital ratios are higher, and their balance sheets are stronger, so they are better positioned to weather an economic storm. Within the portfolio, Wells Fargo is an example of a self-help story. It has had to spend more than its peers in recent years to get back on track following a series of scandals. The company has now worked through most of its issues and can think about reducing costs. BRSA’s managers are avoiding regional banks as they are less diversified and loan losses are likely to have a more significant negative impact on their balance sheets than those of money-center banks.

The trust remains underweight the industrials (-7.0pp) and real estate (-3.5pp) sectors on valuation grounds, but DeSpirito, Zhao and Yang also consider fundamentals in the real estate sector are unattractive. There has been overbuilding and the shift from bricks and mortar to online retailing has increased the supply/demand imbalance. Given the 90% payout ratios, investors flocked to real estate stocks seeking yield during a period of low interest rates. Now interest rates have started to rise there have been asset allocation shifts from equities to fixed income securities and the managers expect this trend to accelerate.

DeSpirito, Zhao and Yang highlight a few recent changes in BRSA’s portfolio. New positions include JPMorgan Chase & Co, which has an attractive valuation. The managers consider that the company has a better business mix now than at any time in its history, and also has a very strong management team. Humana is a health maintenance organisation, which is one of the areas favoured by DeSpirito, Zhao and Yang within the healthcare sector. They are less keen on pharma stocks due to the prospect of further drug pricing legislation. Axalta Coatings Systems is heavily exposed to the automotive sector, where the managers expect production to improve from recessionary levels and supply chain disruptions to be self-correcting.

Recent complete disposals include Zimmer Biomet Holdings, a medical device business where DeSpirito, Zhao and Yang think the company’s opportunity set is no longer as robust as it was. Warner Bros. Discovery has made a series of acquisitions, the managers are unimpressed with the company’s leadership team, and they consider the firm is less well-positioned with regards to its streaming assets compared with its peers. Home improvement retailer Lowe’s Companies business had a considerable tailwind during COVID-19 and this benefit is now waning.

Exhibit 7 shows BRSA’s relative performance. The most relevant period is SC, which is since the trust’s change in strategy at the end of July 2021. Since then, BRSA has underperformed the reference index.

The last six months have been a little challenging. Negative contributors include not holding oil majors Chevron Corporation and ExxonMobil Corporation, whose share prices have been supported by elevated commodity prices and BRSA’s position in Dentsply Sirona, which has now been sold. While the volume of dental procedures continues to recover from COVID-19-affected weakness, this company’s business is more economically sensitive compared with other parts of the healthcare sector. It is also involved in some of the lower growth areas of the dental industry such as metal braces.

Positions that have made a positive contribution to the trust’s performance include holdings in energy companies EQT Corporation, Hess Corporation, Sempra Energy and Australia-listed Woodside Energy Group, along with American multinational managed healthcare and insurance company Cigna Corporation.

It is worth highlighting BRSA’s significant outperformance versus the broad UK market over the last one, three and five years, although it has done less well versus the US bellwether S&P 500 Index, whose performance has been dominated by growth stocks.

BRSA is one of seven funds in the AIC North America sector that follow a variety of different mandates (both the Canadian companies have an allocation to US equities). Its distinguishing features are a relatively concentrated portfolio offering an attractive level of income and capital appreciation potential, premium ESG scores and lower carbon emissions. BRSA’s closest peer is abrdn’s North American Income Trust, whose portfolio is split between US equities (c 90%) and Canadian equities and cash (c 10%). Of the two funds, BRSA’s NAV total returns are the highest over three and five years.

Compared with the whole sector, the trust ranks fourth out of seven funds over the last year, sixth out of seven funds over the last three years, fifth out of six funds over the last five years and third out of five funds over the last decade. BRSA has the second-lowest discount in the sector and an ongoing charge that is modestly above average, ranking fourth. It has a below-average level of gearing and the second-highest dividend yield, which is 1.6pp above the mean.

BRSA’s earnings per share in H122 (ending 30 April) were 1.82p, which was 28.9% lower than 2.56p in H121; changes to the investment mandate and the decision to stop writing covered call options have negatively affected the trust’s level of income. So far in FY22, three interim dividends of 2.0p per share have been paid, which were in line year-on-year. At the end of H122 the trust had c £124.7m in distributable reserves, which are equivalent to around 19x the last annual dividend payment. Based on its current share price, BRSA offers a 4.0% dividend yield.

BRSA is trading at a 6.6% discount to cum-income NAV, which compares to a range of a 0.5% premium to a 10.4% discount over the last 12 months. It is not dissimilar to the average discounts of 5.3%, 4.5%, 3.1% and 3.6% over the last one, three, five and 10 years respectively.

Renewed annually, BRSA has the authority to repurchase up to 14.99% and allot up to 10% of its share capital. In November 2020, 190k shares were repurchased at an average 6.8% discount, costing c £0.3m, while in April 2021, 445k shares were reissued from treasury at an average 1.7% premium to NAV for a gross consideration of c £0.9m. No further shares have been repurchased or reissued since then.

BRSA was launched on 24 October 2012 and is listed on the Premium Segment of the London Stock Exchange. It is managed by three of BlackRock’s US income & value investment team: Tony DeSpirito (CIO, US fundamental equities), David Zhao (co-director of research) and Lisa Yang (consumer discretionary/staples specialist). There are more than 30 people in the US income & value team, which has c $60bn of assets under management. BRSA’s managers primarily invest in a diversified portfolio of North American equities, focusing on large- and mid-cap companies that pay and grow their dividends. To mitigate risk, at the time of investment, a maximum 10% of gross assets may be invested in a single investment, a maximum 25% in non-North American companies, and a maximum 35% in any one sector. The managers also take firms’ ESG characteristics into account seeking to deliver a superior ESG outcome compared with the reference index in terms of a better ESG score and a lower carbon emissions intensity score. Foreign currency is not hedged as a matter of course, but the managers may employ specific currency hedging.

There are three main elements to BRSA’s investment process:

Idea generation – the managers aim to identify the best ESG and alpha opportunities from an investment universe primarily made up of North American large- and medium-cap equities, although up to 25% of the portfolio can be invested in liquid non-North American companies. ESG exclusion screens are used to narrow the investment universe. The managers are able to leverage the best fundamental and thematic ideas from BlackRock’s US income & value platform to generate a pipeline and prioritise the research agenda.

Fundamental research – this involves assessing the materiality of a firm’s ESG and sustainability factors and evaluating its important earnings drivers, along with engaging with company managements on business and ESG issues. A research document is prepared to illustrate the investment thesis and is discussed within the investment team. The managers evaluate how and over what time frame they expect their research insights to be reflected in a company’s share price.

Portfolio construction – the fund typically has 30–60 high-conviction positions. Gearing of up to 20% of NAV is permitted, but is likely to be in a 0–10% range, with 5% seen as a neutral level. There are clear buy and sell disciplines for both fundamental and ESG considerations. Portfolio risks and exposures are carefully monitored, with an emphasis on stock-specific risk. The fund is diversified by sector, industry and style factors.

DeSpirito, Zhao and Yang seek to build a high-conviction portfolio of attractively priced, high-quality dividend-paying companies that are classified as either: ESG leaders – best-in-class companies that effectively manage environmental, social and governance factors to benefit all stakeholders such as Cisco Systems; ESG improvers – companies showing demonstratable progress on their ESG journey, where active engagement may lead to improving ESG practices and more sustainable outcomes such as Wells Fargo; and ‘sustainability enablers’ – firms advancing the transition to sustainable solutions, such as companies contributing to greater energy efficiency and a lower carbon footprint.

Outright exclusions from the fund include businesses manufacturing controversial weapons or civilian firearms, fossil fuel miners (thermal coal and tar sands) and tobacco companies. BRSA’s resulting portfolio has a premium ESG score and lower carbon emissions intensity than the reference index, as measured by MSCI, which is a leading external ratings agency.

As shown in Exhibit 11, at 31 July 2022, compared with the reference index, BRSA’s portfolio had the same dividend yield, a modestly lower return on equity, a lower forward earnings growth and a lower forward P/E multiple. The portfolio had higher ESG scores in all three of the subsectors – environmental, social and governance, while its carbon emissions intensity is around half that of the reference index.

Gearing of up to 20% of NAV is permitted but is typically in a range of 0–10%, with 5% deemed a neutral level. At end-September 2022, BRSA had net gearing of 4.0%.

BlackRock Investment Management (UK) is paid an annual management fee of 0.70% of BRSA’s NAV (0.75% before 30 July 2021). This is allocated 75% to the capital account and 25% to the revenue account. In FY21, the trust’s ongoing charges were 1.06%, which was in line with FY20. The board anticipates that this will decline to less than 1.00% in FY22.

BRSA is a conventional investment trust with one class of share. There are 80.2m ordinary shares in issue. At end-FY21, 96.4% of the trust’s shares were held by banks or nominees (including retail investor platforms), which was a modest decrease compared with 98.1% at end-FY20. BRSA’s average daily trading volume over the last 12 months was c 105k shares.

Simon Miller retired at the end of BRSA’s FY22 (31 October). The new chair is Alice Ryder. Melanie Roberts purchased 10,000 BRSA shares in June 2022 and David Barron purchased 5,000 shares in August 2022.