Securities Trust of Scotland — Update 8 March 2016

Global stock markets are in a period of heightened volatility. For example, year to date the CBOE Volatility index in the US is significantly above the averages of the last one, three and five years. Investor concerns centre on slowing global growth, weak commodity prices and geopolitical concerns. Until there is clarity on some of these macro issues, volatility in the stock markets may continue. However, forecasters such as the IMF look for growth to continue and global equity valuations in terms of forward P/E multiples are now more reasonable than the averages of the last 12 months.

For the first six weeks of 2016 the MSCI World High Dividend Yield index outperformed the MSCI World index by c 5% (-5.8% vs -10.6%); a partial clawback of the 10% total return underperformance of the high dividend yield index versus the broader market in the three-year period to the end of 2015. With similar valuations between the MSCI World High Dividend and MSCI World indices on both forward P/E and price/book multiples, investors may find the higher dividend yield of a fund investing in high-quality growth companies appealing.

STS was incorporated in 2005 as part of the reconstruction of its namesake predecessor trust. It is managed by Martin Currie, which since October 2014 is an independently managed investment affiliate of Legg Mason. In 2011 the mandate was changed to focus on global rather than UK stocks and the MSCI World High Dividend Yield index was adopted as the benchmark. Manager Alan Porter seeks to invest in undervalued companies with rising income and the potential for long-term capital growth. In the current low-growth economic environment, the focus is on structural growth companies and those adopting self-help strategies. The portfolio consists of 40-60 stocks selected on a bottom-up basis. A revised dividend policy was announced in May 2015, whereby the trust will pay a higher dividend from both capital and income; the current yield is 4.4%.

Manager Alan Porter comments that economic activity was subdued in 2015. Emerging markets represent 70% of global growth but have seen declining growth for the last five years, while developed markets are experiencing a modest recovery. He suggests there are three key transitions influencing the outlook: a slowdown in China and rebalancing from an investment to a consumption-led economy; lower commodity prices; and a gradual tightening of monetary policy in the US while several other advanced economy central banks continue to ease. A strong dollar has weighed on the performance of US exporters and affected emerging market economies with dollar-denominated debt.

Equity valuations are viewed as high but not extreme and dividend yields are attractive. On a sector basis, energy, material and utility earnings are under pressure. Consumer sectors are experiencing robust demand and benefit from lower commodity prices, but valuations are expensive. The MSCI World index is trading at c 15x forward earnings with most sectors trading around this level; outlying sectors are financials (c 10x), consumer staples (c 20x) and energy (where estimates are collapsing as a result of the weak oil price).

In a challenging macro environment, the manager is looking for long-term business models with sustainable revenues that should feed into profits, cash and dividend streams. Favoured investments are in companies with structural growth, self-help strategies or in a recovery mode where there is not an overreliance on strong economic growth.

Stocks are selected on a bottom-up basis and are either large- or mid-cap. The investment process has three stages:

Following the appointment of Mark Whitehead in 2015, the Martin Currie income team is now comprised of seven people: four portfolio managers and three analysts focusing on global, European and UK portfolios. Manager Alan Porter stresses the benefits of the larger team, which has the resources to devote more time to company models and stress-testing investment assumptions, as well as encouraging more debate and generating investment ideas. The larger team illustrates the importance of income investment at Martin Currie, which forms one of the three pillars of the business.

As at 31 January 2016, STS held 44 stocks with the top 10 positions representing 37.8% of the portfolio compared to 40.6% at the end of January 2015. Six companies were in the top 10 list in both periods. Active share (a measure of the differentiation between the holdings in a portfolio versus its benchmark) is high, currently at 86.9%. Over 20% of the portfolio is held in stocks that are not in the index.

Comparing STS’s portfolio to the benchmark, the forward P/E multiple is modestly higher and the dividend yield is fractionally lower, this is partially due to the recent Kinder Morgan dividend cut. The debt to equity ratio is substantially higher, but the manager explains this is due to positions in REITs, for example Crown Castle, which carry a lot of debt and REITs are not included in the benchmark index.

On a sector basis, STS is overweight financials due to real estate exposure. A recent addition to the fund was Unibail-Rodamco – the largest commercial real estate company in Europe, which has solid mid-single digit revenue growth and strong cash generation. The portfolio is neutrally weighted in banks (although no US banks are held) and is underweight insurance. The underweight positon in energy is due to the weak oil price and within IT the manager finds it difficult to find companies that fit the remit.

STS did not keep pace with the benchmark in 2014 and 2015, which has weighed on the longer-term cumulative performance. In absolute terms, however, the NAV and share price total returns have been in excess of 7.5% a year over five years. Relative to the FTSE All-Share index, the trust’s NAV has outperformed over all the periods shown in Exhibit 6.

The manager comments that performance in 2015 was all about the fourth quarter, where the fund lagged the benchmark by 2.5%. This was due to four specific stocks:

In August 2011, STS moved from a UK to a global mandate. The discount narrowed and the shares traded at a premium until mid-2014. STS’s current share price discount to NAV of 7.0% is wider than the averages over the last one, three, five and 10 years. Over the past 12 months the discount has ranged from 1.6% to 8.4%.

STS’s discount policy states that if the average discount during the 12 weeks before the trust’s March fiscal year end exceeds 7.5%, a redemption opportunity is triggered. Over the year to date, the company has been actively repurchasing shares. The willingness to buy back shares to contain the discount is in keeping with the issuance of new shares to manage a premium (as shown in Exhibit 1).

STS has a simple capital structure with one class of share; as at 29 February there were 114.7m shares outstanding. Borrowing is via a £17m revolving loan facility with State Street, which expires on 25 September 2016. At 30 September 2015 it was fully drawn at an interest rate of 1.28%. Gross gearing of up to 15% is permitted; at 31 January it was 10.6%.

The annual management fee is 0.6% of net assets, payable quarterly, allocated 65% to capital and 35% to revenue, in accordance with the board’s expected long-term split of returns in the form of capital gains and income. There is no performance fee following the board’s decision to simplify the fee structure. Ongoing charges for FY15 were 1.0%, in line with the prior year.

Dividends are paid quarterly in September, December, March and June. In May 2015, the board announced a change in its dividend policy to address the relatively low yield on which STS had traded relative to some of its peers. The dividend may now be paid in part from capital. This is deemed to be more attractive on a risk/reward basis than increasing the gearing or investing in higher-yielding stocks. Based on the current number of shares outstanding, at the end of September 2015, STS had distributable reserves of 108.9p per share: a special reserve of 89.0p per share, a capital reserve of 17.5p and a revenue reserve of 2.4p. A minimum annual dividend of 5.80p for FY16 was announced in advance, which implies that the final dividend will at least match the three interim dividends already paid/announced (1.45p) and would represent an 18% increase versus the previous year.

There are 11 trusts in the Association of Investment Companies’ Global Equity Income sector. STS’s NAV total return is above the average over one, three and five years. It should be noted that the averages are skewed downwards by the Murray International Trust. In terms of risk-adjusted returns, STS has a higher Sharpe ratio over both one and three years. The discount is slightly wider than the peer group average and the ongoing charge is lower. Unlike some of the peers, there is no performance fee. Net gearing and dividend yield are modestly lower than the average.

STS has six directors. Neil Donaldson was appointed chairman when the trust was reconstructed in May 2005; having served on the predecessor’s company board since launch. Andrew Irvine (senior independent director) has the same tenure as Mr Donaldson. Rachel Beagles was appointed in July 2010, Angus Gordon Lennox in November 2013 and Mark Little in October 2014. The newest member of the board is John Evans; he was appointed in February 2016.