BlackRock Sustainable American Income Trust — Unique value/ESG fund at an attractive valuation

BRSA has a dual objective to outpace the performance of, and to ensure that its portfolio ESG characteristics (as measured by MSCI) are higher than those of its reference index. With its focus on bottom-up stock selection, the trust is well positioned to take advantage of a stock market that is driven by company fundamentals rather than macroeconomic developments. While the US market was led by the ‘magnificent seven’ technology stocks in 2023 (Apple, Amazon.com, Alphabet, Microsoft, Meta Platforms, Nvidia and Tesla), they are suffering mixed fortunes in 2024. A broader market leadership should also be beneficial for BRSA’s performance.

The S&P 500 has performed significantly better than both US value stocks and the UK market over the last decade. A large part of this has been due to the outperformance of large-cap technology shares, which were particularly strong in 2023 helped by their exposure to artificial intelligence (AI), which is deemed to have significant, long-term growth potential.

The valuation of the broad US market continues to look unappealing. As shown in Exhibit 3, using Datastream indices, on a forward P/E basis the US is trading at a c 24% premium to the world market, and its 20.5x multiple is a 13% premium to its 10-year average. The US is also trading on a much higher price-to-book multiple than the world market. Although the US market has a superior return on equity, it offers a meaningfully lower dividend yield.

Yang says that although BRSA’s stock selection is on a bottom-up basis, the managers do consider the macroeconomic background. She notes that the US economy has held up well, helped by COVID-19 stimulus, and the labour market has remained strong. The manager believes that the US is in the later stages of the current economic cycle, and there is a risk that higher wages could put upward pressure on inflation (keeping it above the targeted 2.0% level), limiting the Federal Reserve’s ability to reduce interest rates. Yang considers this scenario presents a risk to the US stock market, as the consensus expectation is for lower interest rates.

The manager highlights that the current forward P/E multiple of the US market is notably above its long-term average. However, she sees opportunities in US value stocks, which are trading at a record discount to the overall market. Yang points to a recent publication by BlackRock that suggests while passive investment has been increasingly favoured by investors, going forward, active management will be more important. Following the global financial crisis and before the onset of COVID-19, there was a unique period known as the great moderation, where interest rates, inflation and stock market volatility were low, and there was a narrow dispersion of equity returns. The manager anticipates increased stock market volatility and a higher dispersion between equity returns, due to sticky inflation, higher interest rates and other factors including geopolitics and decarbonisation, which she says makes a strong case for active versus passive investment.

Yang highlights that looking back to 1975, following a peak in interest rates there has been a subsequent recession. With the valuation gap between the reference index and the bellwether S&P 500 Index at the widest point versus history, the manager sees opportunities to invest in high-quality stocks with strong cash flows, robust balance sheets and well-regarded management teams. Yang says that high-quality and low-beta stocks tend to outperform following interest rate hiking cycles and she is finding examples of these types of stocks in the consumer staples and healthcare sectors that are trading on lower valuation multiples than their 1996–2023 historical averages. This suggests that investors are not positioned for a stock market downturn.

Exhibit 4 shows BRSA’s geographic exposure. Over the 12 months to the end of March 2024, there is a notably higher allocation to US stocks (+7.2pp). This was partially offset by the disposal of the trust’s Japanese stocks (-3.9pp) and a lower UK weighting (-2.3pp).

While the US market provides a wide opportunity set, Yang says that with this market trading at a premium valuation multiple to its historical average, better opportunities may be found overseas. She highlights the global pharma industry, where US companies are facing declining revenues due to an impending patent cliff, so they need to invest to bolster their product pipelines. The manager contrasts this with European pharma companies, whose revenues are expected to rise over the next decade based on their base revenues, with any successful product launches providing incremental sales.

There were modest changes in BRSA’s sector exposure in the 12 months to the end of March 2024 (Exhibit 5). Yang explains that the trust has been overweight healthcare stocks for a long time because of the industry’s structural growth drivers, which are supported by an ageing global population. BRSA’s largest overweight position is technology. An increasing number of stocks in this sector are what the managers refer to as industrial technology, which are companies with defensible competitive positions, well positioned to take advantage of long-term growth opportunities and are generating strong earnings and cash flow. This has led to a growing number of technology companies paying dividends to shareholders. The trust retains a notable underweight exposure to industrial stocks given the advanced stage of the current economic cycle and generally unattractive valuations. Other underweight sectors include real estate as these stocks are unattractively valued and utilities because the managers consider that climate change risks are not priced into these companies’ stock prices.

At the end of March 2024, BRSA’s top 10 holdings made up 26.1% of the portfolio, which was a modestly lower concentration compared with 27.3% a year before; five positions were common to both periods.

Comparing BRSA’s portfolio with the reference index at the end of January 2024, it had a similar gross dividend yield and considerably higher dividend growth. Its return on equity and forward earnings growth outlook was modestly lower but the portfolio was more attractively valued at a c 20% discount to the reference index and a much wider discount versus the US market.

As normal, in Q124, portfolio activity occurred across a range of industries. The largest purchases included: Avnet (electronic products distribution); Diageo (UK-based, alcoholic beverages); PG&E (electric and natural gas utility); Sensata Technologies (sensors); WPP (UK-based, communications and advertising); and Westinghouse Air Brake Technologies (transportation equipment).

The following positions were sold: Acuity Brands (lighting and building management); First American Financial (financial services); Gildan Activewear (Canada-based, apparel); Komatsu (Japan-based, construction, mining & utility equipment); Mattel (toys); Nestlé (Switzerland-based, food & beverages); and TransUnion (consumer credit ratings).

There are seven companies in the AIC North America sector; five US and two Canadian funds, which can also invest in US equities. The companies all have different investment mandates; BRSA is unique with its value and ESG focus. Its NAV total returns are above average over the last three years, ranking third, and below average over the last one, five and 10 years. An analysis using Morningstar data shows that BRSA’s closest peer is abrdn’s North American Income Trust (NAIT); they are the only two companies in the sector designated as large-cap value funds. BRSA’s returns are superior to NAIT’s over all periods shown in Exhibit 9. It has the second-highest valuation in the sector, behind JPMorgan American, which is trading at a small premium. BRSA has an average ongoing charge and a below-average level of gearing. The trust has an attractive dividend yield, which is the third highest in the peer group and 1.4pp above the sector average.

BRSA’s relative returns are shown in Exhibit 10. The trust has underperformed its reference index since the 2021 strategy change. Yang explains that this is largely due to a single stock, Meta Platforms (formerly Facebook), which entered the reference index in 2023. Meta was not added to the portfolio as it did not meet acceptable ESG credentials; unfortunately, the company’s share price rallied strongly, which negatively affected the trust’s relative performance by c 150bp. Meta has since returned to the reference index’s peer US 1000 growth index.

Exhibit 13 shows BRSA’s upside/downside capture over the last 10 years. The fund’s defensive qualities are illustrated by its upside capture of 93% and downside capture of 92%, which are both less than 100%. These numbers suggest that the trust will capture around 10% less than the reference index’s moves both in months when share prices rally and in months when they fall.

In FY23, BRSA’s earnings were 3.67p per share, which was 4.4% lower year-on-year. Four regular dividends of 2.00p per share were paid. The total annual payout of 8.00p per share has been held steady for the last seven financial years and is expected to continue in FY24 using revenues and distributable reserves. At the end of FY23, the trust had c £152.3m in distributable reserves, which is equivalent to c 24x the annual dividend payment.

BRSA’s 8.8% discount compares to a range of a 1.3% premium to a 13.6% discount over the last three years. It is wider than the 8.6%, 6.2%, 4.6% and 4.9% average discounts over the last one, three, five and 10 years respectively. Renewed annually, the trust’s board has the authority to repurchase up to 14.99% and allot up to 10% of its share capital. Due to the prevailing discount to NAV in October 2023, when, in general, investment companies’ discounts had widened to levels last seen during the global financial crisis, BRSA’s board restarted share buybacks. Shares are currently being repurchased regularly and are held in treasury.

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 around 25 investment professionals in the US income & value team, which has c $65bn 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:

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 17, at 31 October 2023, compared with the reference index, BRSA’s portfolio had higher ESG scores in all three of the subsectors (environmental, social and governance), while its carbon emissions intensity was 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 the end of March 2024, BRSA had a net gearing position of 1.3%.

BlackRock Investment Management (UK) is paid an annual management fee of 0.70% of BRSA’s NAV, which is allocated 75% to the capital account and 25% to the revenue account. In FY23, the trust’s ongoing charges were 1.03%, which was a 2bp increase versus 1.01% in FY22.

BRSA is a conventional investment trust with one class of share. There are 77.0m ordinary shares in issue plus another 23.4m held in treasury. At the end of FY23, 78.7% (vs 96.7% at the end of FY22) of the trust’s shares were held by banks or nominees, individuals 18.0% (vs 1.4%) and other 3.3% (vs 1.9%). BRSA’s average daily trading volume over the last 12 months was c 156k shares.

Alice Ryder has been a director for more than 10 years, partly to provide continuity, and has announced her intention to retire from BRSA’s board at the March 2025 AGM. David Barron will become the chair. A search is underway for a new director and an announcement will be made in due course.