UIL — Seeking undervalued assets across the globe

Exhibit 2 (LHS) shows the performance of indices (in sterling terms) over the last 10 years. The world market has outperformed both UK and emerging markets over this period, as global indices are dominated by the US, which has performed relatively strongly in recent years, helped by its accommodative monetary policy and robust corporate earnings growth. Investors in overseas equities have also benefited from sterling weakness following the Brexit vote in June 2016.

After a particularly benign period in 2017, share price volatility has picked up in recent quarters as investors focus on the prospects for economic growth and interest rate expectations. Current growth headwinds are exacerbated by the ongoing dispute between the US and its trading partners, notably China, which is affecting supply chains and business sentiment. Here in the UK, continued Brexit uncertainty is having a negative impact on spending intentions at both the corporate and consumer levels. In its October 2019 World Economic Outlook, the International Monetary Fund forecasts higher GDP growth prospects for emerging markets and developing economies (3.9% in 2019 followed by 4.6% in 2020, led by China and India) compared with developed economies (1.7% in both 2019 and 2020 – above-average growth estimates for the US, with below-average outlooks for Europe and Japan).

Looking at valuations in Exhibit 2 (RHS), markets look somewhat extended in terms of forward P/E multiples, with the world market trading at a 14% premium to its 10-year average. Emerging markets look relatively attractively valued, particularly on an absolute basis, whereas the UK has suffered significant outflows from international and domestic investors, which is reflected in both its absolute and relative multiples. During 2019, the US market has performed relatively well, but leadership has been narrow, led by select technology and consumer stocks that now look particularly expensive. In the UK, there has been a bifurcation between those companies with overseas earnings – which have been favoured by investors – and smaller-cap companies with domestic operations, which are looking particularly unloved.

In an environment of slowing economic growth and above-average valuations, investors may be well served by focusing on niche growth opportunities that are trading on reasonable multiples.

UIL’s predecessor, Special Utilities Investment Trust (SUIT), was launched in August 1993 as a split-capital fund investing in utilities. In August 2003, its income shares were redeemed at par and the capital shareholders were given the option for a cash exit or to roll their existing capital shares into a new fund, Utilico Investment Trust (UIT – c 70% elected to roll over). Given a number of challenges and regulatory headwinds in the European utility sector, UIT’s mandate was changed to invest in undervalued companies across a range of industries, rather than focusing on the infrastructure, utility and related sectors.

UIL is the successor vehicle to UIT and began trading on 20 June 2007 as a Bermuda-registered company. It is now listed on the Specialist Fund Segment of the London Stock Exchange (see following section). On 5 November 2019, UIL announced a secondary listing on the Bermuda Stock Exchange. UIL is managed by ICM Investment Management and ICM (collectively referred to as ICM). It aims to identify and invest in compelling long-term investments across the globe, where the forecast underlying value is not reflected in their current share price.

The company may invest in shares, bonds, convertibles and other types of securities, including non-investment grade bonds and unlisted securities (up to 25% of gross assets at the time of investment). Derivative instruments are permitted for investment purposes and efficient portfolio management. There are no restrictions on UIL’s sector and geographic exposure, but at the time of investment, no single investment will exceed 30% of gross assets. The company employs a levered strategy through zero dividend preference (ZDP) shares and a limited amount of bank debt (see Capital structure and fees section on pages 10 and 11). At end-October 2019, net gearing (ZDP shares plus borrowings) was 68.0%.

UIL’s performance is benchmarked against the FTSE All-Share index. Data from UIL show that since inception to end-FY19 (30 June), its NAV total return compounded at a rate of 13.4% pa, which compares very favourably with the 8.1% pa total return of the FTSE All-Share index.

Following shareholder approval at a special general meeting on 9 October 2019, UIL transferred its listing from the Premium Segment of the Official list to the Specialist Fund Segment of the London Stock Exchange with effect from 7 November 2019. Independent shareholders almost unanimously supported the transfer with only 0.19% voting against the proposal. The meeting followed an announcement in July 2019 that the number of UIL’s shares in public hands was close to the 25% minimum threshold. This is a result of the company continuing to buy back shares, along with share purchases by the board members and ICM’s managers. As at 30 June 2019, ICM manager Duncan Saville had a 70.5% interest in UIL’s issued share capital, which included the holdings of General Provincial Life Pension Fund (62.1%) and Permanent Mutual (7.6%). The Specialist Fund Segment does not have any free-float requirements. UIL’s ZDP shares continue to be listed on the Standard Segment of the Main Market of the London Stock Exchange. The Specialist Fund Segment is designed to appeal to specialist funds and sophisticated investors; shares listed here may have limited liquidity and have greater share price volatility than shares listed on the Main Market. Data from the London Stock Exchange show that in August 2019, 42 closed-end investment funds were listed in this segment, with an average market cap of c £300m.

ICM’s investment teams are led by Duncan Saville and Charles Jillings. Jillings is responsible for day-to-day management. His view on the macro backdrop is that the noise around ongoing topics is clearly having an impact on the global economy and asset markets; and that it is difficult to be confident in the outcomes. The manager is concerned about the relationship between the US and China; his view for some time has been that the issue is not just about trade, and the frictions are much deeper, which could cause significant economic headwinds in the future. Regarding Europe, Jillings says the EU’s relationship with the UK is a concern. The UK is the sixth-largest economy in the world, so lower growth here will also affect European growth, which is already subdued. He is more positive on the outlook for emerging markets, as most of these countries’ authorities are pursuing policies to promote economic growth, such as in China, India and Brazil. The manager points to Brazil, where interest rates are at record lows, pension reform has been voted through and the government is encouraging foreign ownership of Brazilian companies. Jillings says that China and India are also ‘energising their economies’.

Although global growth is slowing, the manager says that for the type of investments UIL seeks, he is still finding compelling opportunities. ICM’s managers are total return, bottom-up investors rather than focusing on global stock markets and the macro environment. Jillings explains that ICM’s process is common across all platforms. All of the investment teams are looking for deep value in their respective spaces, either mispriced growth or mispriced asset-backed companies. He says the majority of investments require a degree of active engagement, so as a result UIL is in the relatively ‘active management’ camp. In terms of earnings support, the manager argues that interest rates are low or declining further, which is a benign or positive environment for many businesses; however, he observes higher levels of debt at the personal, corporate and government levels, which he suggests will become unsustainable at some point, and put pressure on earnings.

Jillings says he ‘can see a lot of disruption coming’, believing that regardless of a company’s business, all firms will experience technological disruption, either directly or indirectly. The manager believes the financial services sector is already disrupted and highlights UIL’s position in Afterpay Touch Group, which ‘has turned a piece of the payments market on its head’. It allows retailers to offer customers the ability to buy now and pay later in instalments, without affecting their credit scores (as long as payments are made on time); this is proving very popular with the millennial generation. Afterpay receives a small percentage (around 4%) of the retailer’s sales, and fees from the customer for non-payments (if a payment is missed, no more credit is available). In the UK, the company trades as Clearpay and has recently signed a contract with Marks & Spencer, allowing its online customers to spend between £30 and £800, repaying in four instalments.

UIL is managed by ICM, a specialist investment manager with c £15bn of assets under management (both directly and indirectly). The investment teams are led by Duncan Saville and Charles Jillings, both of whom are chartered accountants with backgrounds in corporate finance and asset management. Other senior members of the investment team are Jacqueline Broers, Jonathan Groocock and Mark Lebbell (covering the utilities and infrastructure sectors); Gavin Blessing (fixed income); Dugald Morrison (resources); Jason Cheong (technology); and Alasdair Younie (financial services).

The fund’s objective is to invest in undervalued assets across the globe. Reasons for a business to be under priced may include: technological change, an underperforming management team or shareholder apathy.

Around 65% of the portfolio is invested via ICM-managed funds, or ‘platforms’, principally Somers (financial services), Utilico Emerging Markets Trust (emerging markets utilities and infrastructure), Zeta Resources (natural resources) and Allectus Capital (technology, with a particular focus on fintech) (see Current positioning for a fuller explanation of each platform).

Jillings highlights what he believes to be the benefits of this approach:

The remaining c 35% of the fund is in direct holdings including Afterpay Touch Group and Optal (holdings in the Allectus Capital platform before distributing to shareholders in 2016), and Resolute Mining. At end-FY19, around one-third of the fund was invested in operating companies and the total number of companies in the portfolio (including the platforms) was 42.

UIL’s portfolio is constructed after incorporating the manager’s three medium-term views on the macro backdrop into account: global financial markets are over-indebted; technological change provides the opportunity for strong investment returns; and emerging markets offer higher GDP growth opportunities than developed markets.

Jillings believes in the importance of supporting investee companies with their capital requirements while maintaining an active and constructive shareholder approach, including reviews of their capital structure and business efficiencies. UIL may often be among an investee company’s largest shareholders and maintains regular contact with them. There is no limit as to how much of a company UIL may own and it may sometimes take legal or management control of a firm. When industries are going through change, the company wants to be a substantive shareholder to enable it to have a voice.

The manager says sometimes when he invests in companies, they are not the opportunities that sparkle; however, they can provide visibility on other companies that are ultimately much stronger investments. These may evolve into platform investments, such as resources-focused investment holding and development company Zeta Resources, which was launched in June 2013.

UIL has a concentrated portfolio. At end-October 2019, its top 10 holdings made up 90.8% of the fund, marginally higher than 89.4% a year earlier; eight positions were common to both periods (Exhibit 1). However, it should be noted that each platform investment holds a number of underlying positions, thereby significantly reducing portfolio risk.

Looking at the company’s geographic exposure (Exhibit 3), Australia is the largest segment in the portfolio, although the weighting declined by 6.9pp over the 12 months to 31 October. Other notable changes are a fall in UK exposure (-7.3pp), with higher weightings in continental Europe (+5.2pp) and Bermuda (+4.8pp).

In terms of UIL’s sector exposure (Exhibit 4), financial services makes up nearly a quarter of the fund. The largest changes over 12 months to end-October are a fall in the technology weighting
(-6.0pp) and increases in infrastructure investments (+4.8pp) and telecoms (+3.0pp).

Jillings highlights some of UIL’s holdings, noting that its investment company (platform) positions are trading at a discount to the value of their underlying investments, effectively affording UIL investors a ‘double discount’, as the fund itself is trading at a greater than 25% discount to NAV. As an example, Utilico Emerging Markets Trust’s shares are currently trading at a c 10% discount to its cum-income NAV.

In FY19 (ending 30 June), UIL’s NAV and share price total returns of 29.7% and 18.8% respectively were considerably ahead of the 0.6% total return of the FTSE All-Share index. Positive contributors to performance included Afterpay Touch (+168.1%), Bermuda First Investment Company (+77.5%), Optal (+60.9%) and One Communications (+51.1%), while NAV performance detractors included the fund’s largest position Somers, which declined by 5.8%.

As shown in Exhibits 5 and 6, UIL has delivered a strong share price total return over the last 12 months (+52.2%) compared to a +23.7% NAV total return, which has led to a meaningful narrowing of the company’s discount (Exhibit 9). Its absolute returns over the last five years are also very robust, helped by the fund’s gearing (NAV and share price total returns of +21.0% pa and +22.1% pa respectively).

UIL’s relative returns are shown in Exhibit 7. Its NAV has outperformed the FTSE All-Share index over most periods shown, particularly over the last one, five and 10 years. This is an imperfect measure given the company only has 12.8% exposure to the UK (although it is relevant for UK investors) so we have also included global and emerging markets indices as comparators. UIL’s NAV has outpaced the performance of the FTSE All-World index over one and five years, and the MSCI Emerging Markets index over one, three, five and 10 years.

Renewed annually, UIL has the authority to repurchase up to 14.99% and allot up to 5% of shares in issue. The company’s discount has narrowed considerably in recent months and there is scope for this trend to continue given the company’s strong investment performance, a lower level of gearing, and regular quarterly dividends. UIL’s board is aiming for a 20% discount, which it believes is achievable over the medium term via continued share repurchases and a higher focus on marketing to existing and potential investors. In FY19, the company repurchased 1.2m shares (1.4% of the share base), at an average discount of 51.2%, and share buybacks have continued in FY20 (2.1m shares, equivalent to 2.4% of the share base).

Based on the 3 December weekly NAV, UIL’s shares are currently trading at a 27.7% discount to cum-income NAV, which is towards the lower end of the 12-month range. This may reflect a recognition by investors of the board’s serious intent to narrow the company’s discount. The current discount is narrower than the 39.2%, 40.0%, 38.1% and 32.2% averages over the last one, three, five and 10 years respectively.

UIL has 86.2m ordinary shares outstanding and follows a levered strategy using ZDP shares and bank debt. It has a £50m senior secured multicurrency revolving facility with Scotiabank Europe (£38.3m drawn). The loan matures in March 2020 and is expected to be extended to 2022.

In the FY14 annual report, the board stated its commitment to reducing the company’s debt and gearing. This has occurred in each subsequent year – gearing was 64.6% at 30 June 2019 versus 87.3% a year earlier, and 160.4% at 30 June 2013. UIL’s current level of gearing is well below the board’s 100% target maximum – 68.0% as at end-October 2019, which is a level the manager is comfortable running.

As shown in Exhibit 10, UIL has four tranches of ZDP shares spread over six years. They are rolled every two years to ensure the portfolio is not disrupted if they are redeemed for cash. Jillings says the company’s ZDP share strategy will continue, as it provides a secure, long-term debt facility. From inception to end-FY19, UIL had issued £373.6m of ZDP shares and redeemed £326.1m; they are issued by UIL Finance, a wholly owned subsidiary of UIL.

In October 2018, the 2018 ZDP shares were redeemed at a cost of £51.2m, using realised investments, while 20.0m 2024 ZDP shares were cancelled (having been held on the balance sheet as standby for the 2018 ZDP share redemption). The board is considering proposals for the redemption of the 31 October 2020 ZDP shares.

UIL’s overall financing costs have declined over the years from an average rate of 6.3% at end-June 2013 to 5.5% at end-June 2019. They should decline further as the board is expecting to refinance the 2020 ZDP shares at a lower rate than the retiring 2020 ZDPs.

ICM is paid an annual management fee of 0.5% pa of UIL’s total assets less current liabilities (excluding borrowings and excluding the value of all holdings in companies managed or advised by ICM or its subsidiaries from which it receives a management fee), along with 45% of ICM’s costs of providing company secretarial services. ICM is entitled to a 15% performance fee on NAV returns above the higher of 5.0% or the UK gilt five- to 10-year index post-tax yield plus RPIX inflation. The NAV must exceed the high water mark NAV from when the performance fee was last paid (adjusted for capital events and dividends) and is capped at 2.5% of financial year-end NAV (adjusted for capital events and dividends paid). It is also reduced to take into account any fees paid to ICM by companies where UIL is an investor.

In FY19, UIL’s ongoing charges (excluding performance fees) were 2.1% (FY18: 2.2%), while including performance fees they were 5.1% (FY18: 4.4%). While these fees may appear relatively high compared with other investment companies as they are calculated on total assets but expressed as a percentage of average net assets (after the deduction of the ZDP shares), based on gross assets the fees are considerably lower.

UIL pays regular quarterly dividends in December, March, June and September and it has the flexibility to pay dividends from capital reserves. In FY19, UIL’s revenue return of 7.63p per share was 14.4% higher year-on-year. The dividend was maintained for the sixth consecutive year, at 7.50p per share and was fully covered for the first time in six years. At end-FY19, the company had revenue reserves of 10.3p per share, which is equivalent to c 1.4x the annual dividend. The board anticipates the annual dividend will be maintained at 7.50p per share and is hopeful that reserves will build; based on its current share price, UIL offers a yield of 3.0%.

Exhibit 11 shows the 16 funds in the AIC Flexible Investment sector with market caps greater than £50m that have been trading for more than three years; they follow a variety of investment mandates. UIL’s NAV total returns are above average over all periods shown, ranking first over one year (+16.2pp), first over three years (+13.5pp), first over five years (+108.6pp) and second over 10 years (+36.5pp). Although narrower than its historical averages, the fund has one of the widest discounts in the selected peer group, and one of the highest ongoing charges. UIL has the highest level of gearing and an above-average dividend yield (1.0pp above the mean).

Two of UIL’s board members, Eric Stobart and Warren McLeland, stood down after the release of the company’s annual report in September 2019. Stobart had served as a director since 2007 and McLeland since 2013. There are now five directors on UIL’s board, four of whom are independent of the manager: