Global growth in capital and income

Looking at Exhibit 2 (left-hand side) the valuations of the Datastream world index vs history, equities do not look immediately compelling. The forward P/E multiple at 14.2x is below the 10-year high of 16.0x, but is 9% above its 10-year average. However, the price-to-book multiple, which can be viewed as a more stable valuation measure, is in line with the 10-year average. In addition, the dividend yield is attractive vs history and returns on equity are improving from the low levels seen in the depth of the global financial crisis. Exhibit 2 (right-hand side) illustrates the relative attractiveness of equities vs bonds from a yield perspective. In the UK, the dividend yield is currently 250bp higher than the 10-year government bond yield.

Notwithstanding the volatile to start to 2016 in global financial markets due to investor concerns about slowing global growth and macroeconomic issues, forecasts are for continuing economic improvement. In the IMF’s latest World Economic Outlook, despite reducing forecasts for world output in both 2016 and 2017 by 0.2%, estimates are for 2.1% GDP growth for both years in advanced economies vs 1.9% in 2015. GDP growth in emerging markets and developing economies is forecast to accelerate to 4.3% year-on-year in 2016 and 4.7% in 2017 vs 4.0% growth in 2015. Global monetary policy remains accommodative; the ECB and Bank of Japan are continuing to ease and following a period of softer economic data in the US, expectations for a further interest rate hike have been delayed. In this period of low, but moderately improving economic growth and low interest rates, a diversified portfolio focused on both capital return and income may be viewed as attractive by investors.

Foreign & Colonial Investment Trust (FRCL) is the oldest investment trust in the UK, launched in 1868. It aims to provide both capital and income growth from a diversified equity portfolio that includes investment in private equity. Dividends have increased annually for the last 45 years. FRCL typically remains fully invested. There are no geography or industry sector exposure limits for publicly listed securities; up to 10% of the portfolio can be invested in private equity and a maximum 5% (excluding private equity) can be invested in unquoted securities. No single investment may exceed 10% and there is a 5% limit on the combined value of investment funds managed by the F&C Group. Derivatives may be used to enhance income or for efficient portfolio management.

Since 1 January 2013, FRCL’s benchmark has been the FTSE All-World index, reflecting a reduction in exposure to the UK and portfolio allocation more in line with the global index. Prior to this the benchmark was a composite of 40% FTSE All-Share index and 60% FTSE World ex-UK index. The portfolio has undergone significant repositioning since the change in investment manager in July 2014, when Paul Niven (BMO’s head of multi-asset investment) took over from Jeremy Tigue, who retired having managed the trust for 17 years. FRCL has a broad shareholder base, including more than 100,000 private investors.

Manager Paul Niven highlighted the FY15 outperformance of FRCL vs its benchmark. Most of the underlying strategies added to performance, such as North America, where the US T Rowe Price growth strategy returned 10%, outperforming the S&P 500 Index and growth indices. Allocations were increased to Japan and Europe, contributing to performance. Private equity was a strong contributor, returning 13.9% in 2015 and generating more than £129m of cash. The weighting has fallen to 9.4% of the portfolio and the manager suggests future exposure is likely to range between 5% and 15% depending on the relative attractiveness of the asset class. When private equity valuations are high and prospective returns are lower than historically, a lower allocation would be desirable. Third-party funds-of-funds were previously invested via HarbourVest and Pantheon (who were paid £4.6m in fees in 2015), but the manager says future private equity investment is likely to be managed internally via primary and secondary investment as well as possible co-investment. This will result in a smaller number of underlying investments and will afford FRCL greater control and lower costs. The manager will have control over the geography and type of investment and will work with the internal team to source them.

Gearing was increased to gain equity exposure in August 2015 during a period of market stress, and decreased in December. The manager is relatively cautious on the economic outlook and notes that gearing has not been significantly increased during the stock market volatility in 2016 as he views the environment as less benign compared to six to eight months ago. He explains that stock markets are driven by corporate cash flows/earnings/dividends and investor risk appetite. Earnings are declining, which is less supportive for equities; negative earnings revisions are not limited to the resource sectors. Profit margins in the US have peaked and are starting to decline from elevated levels. The manager expects pressure from wage gains and higher interest rates. He believes that other regions of the world will outperform the US this year despite elevated macroeconomic risks and that 2016 will be a more difficult year for investors. There has already been rotation in the market, as emerging markets are starting to perform better, along with resource stocks. The manager is looking for the growth/value trade in the US to reverse; in the last three years growth stocks have outperformed value names (measured by the Russell 2000 and S&P 500 growth and value indices).

FRCL’s portfolio is large and diversified and is structured based on the manager’s views on asset allocation, risk and the use of gearing. The objective is long-term growth in capital and income. Investments are primarily in public and private equity given the belief that equities provide the best returns over the longer term. The trust aims to provide market exposure rather than focusing on absolute returns and tactical allocations may be made to address short-term opportunities or threats. The manager is benchmark aware, but the portfolio is not required to follow benchmark allocations; an obvious example is FRCL’s exposure to private equity.

Allocations are made across five regional and three global (including private equity) strategies, with in-house or external manager selection driven by balancing expected return with cost. However, since the acquisition by BMO in 2014, in-house resources are increasingly being used. US small-cap exposure was historically via the Jupiter US Smaller Companies IT (previously a BMO trust), but is now managed internally as part of a global small-cap strategy. There is a Global Equity Income portfolio run by BMO’s Erik Rubingh and a Global Multi-Manager portfolio run by BMO’s Rob Burdett and Gary Potter. Exposure to externally managed funds via a ‘global funds’ portfolio has been reduced; the remaining holdings have been re-allocated into the relevant geographical portfolios.

At the end of February 2016, FRCL had 523 holdings, with the top 10 representing c 10% of the portfolio. Within this there are private equity holdings and fund exposure, so the actual number of companies invested in runs into the thousands. Looking at the sector exposure (excluding private equity), the largest changes in 2015 were an increase in consumer goods and a reduction in oil & gas. The highest overweight position is in consumer services.

As shown in Exhibit 4, on a look-through basis, over the last 12 months the largest geographic changes have been increased exposure to Japan and decreased exposure to North America. The largest overweight exposure is to Europe ex-UK. Following a prolonged period of outperformance, exposure to the US T Rowe Price growth strategy has recently been reduced.

As shown in Exhibit 5, FRCL has outperformed its benchmark over one, three, five and 10 years. The narrowing discount has resulted in outperformance of the share price vs the NAV over three, five and 10 years. The trust has also outperformed the FTSE All-Share index over all periods shown excluding the last month. For the year ended 31 December 2015, FRCL’s NAV total return was 7.5%, which was 350bp higher than the 4.0% returned by the benchmark FTSE All-World index. The share price rose by 9.0%, narrowing the discount. The outperformance was primarily a result of stock selection, although asset allocation also contributed to performance. There were modest share repurchases, which had a small positive contribution and the effect of gearing was positive (shown in Exhibit 7).

FRCL has an active policy to manage the share price discount to net asset value by purchasing shares. In May 2015 the discount ceiling above which shares are repurchased was lowered from 10.0% to 7.5%. This is a step towards the board’s aspiration of the shares trading at or close to NAV. FRCL also has the ability to issue shares when there is a premium. The year 2015 saw the lowest level of repurchases since the policy was introduced in 1999. The current share price discount of 9.9% to cum-income NAV is above the average 7.9% over the last 12 months (range of 5.0% to 11.4%). The change in the discount policy has helped to reduce the average discount; over the last three and five years the discount has averaged 9.2% and 9.7%, respectively.

FRCL is a conventional investment trust with 555.8m shares in issue with a further 6.0m shares held in treasury. The trust uses gearing to enhance returns, which currently stands at 10%. Over the last 10 years, gearing has been in a range of 5% to 19%; it was 8.6% at the end of 2015. Short or long-term borrowings can be taken out in sterling or foreign currencies up to a total of 20% of shareholder’s funds. Borrowing costs have been reduced following the maturity of the long-standing debenture at the end of 2014. A £50m, equivalent seven-year euro loan was taken out in July 2015 at a rate of 1.69% to take advantage of the low interest rate environment. At the end of 2015, around half of total borrowings were short dated with current interest rates between 0.27% and 0.70%. Shorter-term borrowings will be used more actively in terms of currency views, while the currency of structural borrowings will be more closely related to the underlying asset mix. The current blended cost of borrowing is c 1.6%.

FRCL pays a management fee of 0.365% of its market cap to BMO with direct fees also paid to external managers. The manager suggests that the fee structure is competitive, especially for a trust where some of the management is outsourced. In 2015, the ongoing charge was reduced from 0.87% to 0.80%.

Dividends form an important part of shareholder returns and have been increased every year since 1970; they have more than doubled in each of the last four decades. The board recognises the importance of a rising income stream in real terms and has committed to another rise in the dividend in 2016. Since the beginning of 2013 dividends are paid quarterly, previously twice a year. The board has stated that it would like the dividend to be fully covered by revenue income (0.9x in 2015), which rose by 25% year-on-year; however, there is no fixed timeline for full coverage. At the end of December 2015, the revenue reserve was nearly 1.5x the dividends paid in the year. The 9.6p dividend proposed for 2015 is a 3.2% year-on-year increase and the current dividend yield is 2.2%.

The selected peer group shown in Exhibit 8 are members of the AIC’s Global sector with a market cap of more than £100m and less than 25% of their assets invested in the UK. FRCL’s NAV total return performance is ahead of the peer-group average over one, three, five and 10 years; ranking first over one year and second over both three and five years. In terms of risk-adjusted returns, it is in line with the peer-group average over one year and modestly above over three years. The discount is moderately wider and the ongoing charge is slightly above the peer average. There is no performance fee. Gearing is above the group average and the dividend yield is also higher.

There are eight members of the board, all are independent non-executive directors. Chairman Simon Fraser became a director in 2009 and was appointed chairman in 2010. Senior independent director Christopher Keljik was appointed in 2005. The other six directors with their year of appointment are: Sir Roger Bone and Stephen Burley (2008), Jeffrey Hewitt (2010), Sarah Arkle and Nicholas Moakes (2011) and Francesca Ecsery (2013). The board is very diverse; the directors have backgrounds in asset management and a range of industries.

On 8 March 2016, it was announced that Christopher Keljik will be retiring from the board following the next AGM. The search for his replacement is currently being undertaken via an online resource, leading to a broader selection of candidates. Sir Roger Bone will become senior independent director.