The Brunner Investment Trust — Update 17 December 2015

Global markets fell almost in unison in late summer 2015, fuelled by worries over slowing growth in China and the likely trajectory of US interest rates (a 0.25% rise was announced as this note was being finalised), before staging a recovery in October and then falling back again in the run-up to Christmas. As shown in Exhibit 2 (left), performance for global investors in recent years has been dependent on the balance of portfolio holdings between regions. Having moved closely together from late 2012 until mid-2014, the US then outperformed the UK, which in turn outperformed the FTSE All-World ex UK index, (which includes a significant emerging market weighting). The near-term outlook may continue to be dominated by the same uncertainties and a globally diversified portfolio could mitigate the effects of any region-specific shocks, while an actively managed rather than index-hugging approach offers the potential of outperformance in a period of market volatility.

While concerns persist about the level of P/E valuations in some markets and sectors (see page 4 for the BUT managers’ views on ‘bond proxies’), Exhibit 2, right-hand chart shows that in aggregate, the UK and world-ex UK indices are broadly in line with one another on a range of valuation metrics. The main divergence is in dividend yields, where UK yields are c 50% higher. However, as BUT’s managers point out, by taking a selective approach, attractive yields can be found overseas too.

The Brunner Investment Trust (BUT) was created in 1927 to manage the wealth of the Brunner family, one of the founding families of industrial giant ICI. It invests in UK and overseas equities and is managed by Lucy Macdonald and Jeremy Thomas at Allianz Global Investors. Its aim is to achieve long-term growth in capital and income. Dividends are paid quarterly and have risen year-on-year for 43 years. Over recent years the portfolio has become more concentrated, with c 80-90 stocks rather than 100+, and the focus on the UK has been reduced, a move reflected in the change in benchmark in 2008 from 60% UK/40% World ex UK to a 50/50 split. The UK weighting – currently just under 40% – could fall further over time as the managers seek to diversify.

In light of the challenging macro picture, the managers see an element of risk as essential to generating market-beating returns. Thomas points out that globally there is still a large amount of debt, growth is sluggish, companies are struggling to generate revenue growth and many are trading on valuation multiples that are fuller relative to history, while bonds are also fair value to expensive. While monetary policy may be on a normalising trend in the US and UK, interest rate rises are unlikely to be large or numerous, and Japan and Europe are still in monetary easing mode, a situation the managers see as unlikely to change in the near term.

One way to boost returns is to diversify sources of yield away from the UK. Historically, UK stocks in the BUT portfolio have yielded c 4% while overseas stocks have yielded c 2%. The managers are actively seeking opportunities to top-slice UK holdings where valuations look stretched and reinvest in high-yielding stocks elsewhere. An example of this is Spanish commercial real estate company Merlin Properties, which owns offices and retail space in Madrid and is diversifying into Barcelona and Lisbon. The new position has been funded partly by taking profits in UK and Germany-focused Hansteen Holdings. Thomas explains that the UK property recovery began in 2008, while Spanish property troughed in 2013, so the market there has greater potential for asset growth and rental growth, and Merlin has a prospective yield of 4-5% (it will pay its first dividend in respect of the year ending 31 December 2015).

The managers acknowledge the revenue headwind from BUT’s capital structure, with the cost of gearing running at c 10% a year, a level that is hard to mitigate consistently through investment returns. With the first debenture due to mature in a little over two years, however, the drag is beginning to lessen, underpinning the prospects for the trust’s own dividend growth (see page 7).

Dividend growth within the portfolio is also a key focus: Thomas points out that with c 80 stocks from which to generate a yield, there is no need to be straitjacketed by the benchmark. Big UK companies like BP, Shell, Vodafone and BHP Billiton are currently at high yields because their prices are depressed, but are likely to struggle to grow their dividends, giving additional reasons to look further afield for sources of sustainable yield. That said, another group of UK large-caps – the banks – have the potential to produce meaningful dividend growth as regulatory headwinds abate.

The managers caution against over-reliance on ‘bond proxies’ – stocks in areas such as consumer staples and healthcare, which have historically paid solid dividends, but which have been forced up to high prices (putting downward pressure on yields) by investors frustrated by low yields on bonds. “People are buying these companies because they think they are like bonds, but the ‘safest’ stocks are now the most expensive,” says Thomas, adding that in some ways, copper giant Antofagasta –the lowest-cost producer of a depressed commodity, with a share price down 39.6% over 12 months – is ‘safer’ than Unilever, up 12.8% over 12 months and trading at a P/E ratio of 22.5x.

BUT takes a bottom-up approach to investing, picking stocks with help from AllianzGI’s deep and broad research resources, which include 80+ equity analysts, based around the world and organised by sector, as well as a proprietary field-based market research system called GrassrootsSM. AllianzGI’s analysts and fund managers between them meet with more than 5,000 companies a year, with each meeting resulting in an analyst note with a recommendation.

The trust’s managers, Lucy Macdonald (AllianzGI’s chief investment officer for global equities) and Jeremy Thomas (a UK and European specialist) look for quality stocks offering a blend of growth and income. As explained in The managers’ view above, while UK stocks have historically provided more than half of the portfolio yield, there is increasing focus on finding higher yields from overseas stocks. Companies identified through the research process are screened quantitatively to assess upside potential, and risk controls help the managers avoid unintended biases. All purchases and sales are debated by the team, and turnover has historically been low, at c 10% pa.

At 30 November 2015, BUT had 84 equity holdings, two fewer than at the date of our last note, which is in line with the managers’ intention to hold a more concentrated portfolio. The UK portfolio was made up of 34 holdings, making up 38% of the total portfolio, or 42.2% net of cash. There were 50 overseas stocks in the portfolio.

Geographically, the trust is underweight the UK versus its 50/50 FTSE All-Share and FTSE All-World ex UK benchmark, although the underweight net of cash is smaller than that shown in Exhibit 3. Europe is the biggest overweight, underpinned by the managers’ view (expressed via purchases such as Merlin Properties; see page 4) that there are further benefits to be reaped from the economic recovery on the continent, which is at an earlier stage than in the UK or US.

In sector terms, the managers have trimmed the weighting in healthcare – a source of strong performance over the past year – to a level in line with the benchmark (Exhibit 4), while the financials weighting has been boosted through purchases of UK banks such as Barclays and Lloyds, and Asia-focused insurers Prudential and AIA, which the managers feel have been unfairly downgraded on fears over Asian economic growth. Thomas points out that many Asian savers use insurance products to provide the kind of social-security safety net that Britons and Europeans receive from the state, and that such expenditure is unlikely to be cut back because of stock market volatility in Asia. Industrials remain the biggest overweight, although this has been reduced a little over the past six months. The industrials weighting is concentrated in niche market leaders in areas such as support services and factory automation, rather than in the kinds of heavy industry that have been affected by slowing growth in China. Technology remains a theme, with holdings focused on areas such as mobile data, cloud computing and the ‘internet of things’. At a stock level, the largest active weights (based on the 50/50 benchmark rather than individual country weightings) are in Mothercare, Walgreens Boots Alliance, Microsoft, private equity investor Better Capital and United Business Media (UBM).

BUT staged a recovery in October, after being hit by the broad sell-off in late August, outperforming the benchmark to post a one-month NAV total return of 6.3%. Over longer periods (one, three, five and 10 years) the share price total return has beaten the benchmark, while the NAV return has been broadly in line (Exhibit 5). The structural gearing will act to boost performance in a rising market but will amplify any losses. Looking at portfolio performance net of gearing, BUT has returned more than the benchmark over one and six months, and annualised over one, three, five and 10 years.

As seen in Exhibit 6, BUT has outperformed the UK index appreciably over the longer term, though returns versus the non-UK portion of the benchmark have been more muted, most likely as a result of strong performance in the US (55.9% of the FTSE All-World ex UK index) over the period. Over the past year positive contributions have come from healthcare, where Fresenius and UnitedHealth, as well as health-related retailer Walgreens Boots Alliance, are all among the top 10 contributors. A value-focused move into hard-pressed resources stocks may have come too early; half of the top 10 negative contributors over 12 months to 30 September were in the oil & gas or related sectors.

At 15 December, 2015 BUT’s shares traded at a discount to NAV of 11.1% (cum-income, with debt at fair value). This is lower than the one-, three- and five-year averages of 12.6%, 12.9% and 12.5% respectively. Because of the trust’s structural gearing, it is worth considering the discount with debt at par value (Exhibit 8); this tends to be higher because the lower book value of the debt increases the NAV, but the gap is beginning to close as debt maturity approaches. BUT may buy back up to 14.99% of shares annually and can allot up to 10%. The trust tends to use these powers sparingly; the last year of significant activity was 2011, when 1.96m shares were bought back at a cost of £8.0m. No buybacks occurred in 2014 and so far in 2015, 99,000 shares have been bought in, costing £600k.

At 15 December, BUT had 43.0m ordinary shares in issue. The trust is structurally geared (£49.6m of debt), mainly through a stepped-rate loan of £18.2m repayable in January 2018 (market value £21.8m at 30 September), with an average coupon of 11.125%, and a fixed-rate loan of £30.9m repayable in May 2023 (market value £38.6m), with an average coupon of 9.25%. At 30 November, gross gearing was 18.4%, although net gearing is much lower, at 7.5%, due to cash holdings. On a pro forma basis, the removal of the first tranche of debt could boost revenue returns by c 2.4% and add c 50bps a year to capital performance if it used proceeds from selling its c £18m of fixed income holdings (value at FY14) to repay the debt. Refinancing the debt to a notional market rate of 5% would produce a bigger saving in revenue costs but less of an uplift to capital returns.

Allianz Global Investors receives an annual fee of 0.45% of assets minus short-term liabilities. Ongoing charges were 0.79% at the 30 November 2014 year end.

BUT’s progressive dividend policy has led it to increase its annual dividend for 43 years in a row, with a further increase for FY15 likely (the first three interim dividends amount to 9.6p, an above-inflation 3.2% increase on the same period of FY14). Since 2014, dividends have been paid quarterly, in June, September, December and March. The rebalancing of the portfolio to seek more income from overseas stocks may result in a shortfall in revenue while the transition is ongoing; in FY14 0.3p of the 15.0p dividend was funded from reserves. However, with the revenue reserve standing at 31.8p per share at the 31 May half-year end (equivalent to more than twice the FY14 dividend), the impact of a partially uncovered dividend for FY15 is likely to be minimal. Based on its 15 December share price of 514.5p and annualising the latest dividends, BUT currently yields 3.0%.

BUT is a member of the AIC’s Global sector, a diverse selection of 38 funds. Exhibit 10 below includes those with between 30% and 50% of assets invested in the UK, c 10% either side of the BUT weighting. BUT is behind the sector average for NAV total returns over one, three and five years. At 2.8%, the trust’s dividend yield is the highest among the peers shown in the table, and one of the highest in the group. Ongoing charges are average and net gearing is only slightly above the sector average. BUT’s discount is towards the wider end for the sector.

There are six non-executive directors on BUT’s board. Chairman Keith Percy (in post since 2005) joined the board in 2004. Vivian Bazalgette, the senior independent director, was also appointed in 2004. Ian Barlow joined the board in 2009, Peter Maynard in 2010 and Carolan Dobson in 2013. The newest director is Jim Sharp, who represents the Brunner family and became a director in January 2014. The directors have backgrounds in investment management, accountancy and law.