The Brunner Investment Trust — Debt refinancing provides more flexibility

Global stock markets had a bit of a bumpy ride in Q418, as investors focused on slowing economic growth amid further US interest rate hikes. However, the US central bank has since adopted a more dovish stance, suggesting there will be no rate increases in 2019, which has contributed to a significant upward move in stock prices so far this year. Global economic growth will arguably be lower in 2019 compared with last year when US corporate earnings were boosted by lower taxes. In addition, there are a few significant macro issues overhanging the market, including the US-China trade dispute and protracted Brexit negotiations.

While the Q418 stock market pullback led to more reasonable valuations, on a forward P/E multiple basis global shares continue to trade at a premium to their 10-year average (Exhibit 2, RHS). With this valuation backdrop, it would seem reasonable to believe that further equity market moves should be driven by companies’ income growth rather than by a revaluation of share prices. A trade agreement between the US and China, or further clarity on the UK’s exit from the EU, would be supportive for corporate earnings in 2019 (as well as for investor sentiment).

BUT is a well-established investment trust, which launched in January 1927, and is listed on the Main Market of the London Stock Exchange; its largest shareholder continues to be the Brunner family (c 29%). Since 23 June 2016, the lead manager has been Lucy Macdonald, chief investment officer for global equities at AllianzGI. She was previously co-manager focusing on overseas equities and works closely with UK equity specialist Matthew Tillett.

The manager aims to generate long-term growth in capital and income from bottom-up investment in a diversified portfolio of global equities; BUT could be considered a ‘one-stop-shop’ for exposure to world markets. The trust is benchmarked against a composite measure: 70% FTSE World ex-UK index and 30% FTSE All-Share index (previously 50% FTSE World ex-UK and 50% FTSE All-Share until 21 March 2017). To mitigate risk, there are investment limits in place, including a maximum position size of 10% of gross assets in a single stock (at the time of investment). The portfolio must contain at least 50 stocks, diversified by geography and sector. Gearing is permitted up to 20% of NAV at the time of borrowing; net gearing at end-March 2019 was 7.9%. BUT has a 47-year record of growing its annual dividends at a rate higher than the level of UK inflation, and currently offers a 2.3% dividend yield. This compares favourably with the majority of the 20 funds in the Association of Investment Companies (AIC) Global sector.

Macdonald maintains her view that market liquidity (boosted over the past decade by central bank policy) has peaked; however, now that the US’s Federal Reserve has put interest rate hikes on pause, she believes that the liquidity cycle has been extended. The Fed announcement, along with the fact that the US central bank is no longer shrinking its balance sheet, has contributed to significant share price appreciation so far in 2019; however, Macdonald is confident that the strongest boost to liquidity (from QE and extraordinarily low interest rates) is behind us.

Economic growth has slowed, as the manager expected, including in China, which has been negatively affected by the trade dispute, as well as other parts of the globe such as Europe and the US. Macdonald notes negative corporate earnings revisions, which started towards the end of 2018, particularly for cyclical companies, but she suggests revisions could stabilise in the short term. Overall, Macdonald expects mid-single digit earnings growth in 2019, with less regional variation compared with 2018, when US growth was well above average, supported by tax reforms. Given the lower expected variation in regional earnings, the manager also believes there will be more uniform regional stock market performances in 2019.

In terms of valuation, the manager says that on a cyclically adjusted P/E measure, global equities are trading in line with the long-term average. Because of this, she believes there is no justifiable reason to suggest an environment of double-digit returns for global equities. While acknowledging that the stock market bounce this year “has been great”, reversing the Q418 weakness, Macdonald expects the global market to move sideways, with higher levels of volatility due to macro uncertainty; she says this is a good environment for successful active managers. The US-China trade situation is affecting growth and while there may be a resolution, Macdonald says there are other longer-term tensions such as the protection of intellectual property.

The manager explains that so far this year, market leadership has favoured sectors with better earnings momentum, such as technology. She says that quality companies are leading the charge due to a slowdown in global growth, which is benefiting BUT’s high-quality portfolio. Macdonald explains that since the fund was reorganised from a UK and an overseas portfolio to a single global fund in mid-2016, the quality of UK companies held has improved, which has contributed to better relative investment performance.

The manager is able to draw on the broad resources of AllianzGI’s investment team, which along with traditional regional and global research teams, also has professionals focusing on other areas, such as environmental, social and governance (ESG) and the proprietary Grassroots market research platform. Macdonald seeks companies that fulfil three criteria: quality (the ability to generate stable, above-average returns); operating in secular growth markets; and trading at a discount to their perceived intrinsic value on a three-to five-year view. Given the manager expects a more range-bound stock market, with higher levels of volatility, there is an increased focus on a company’s quality attributes such as balance sheet strength and the level of cash flows. There is an ongoing drive to incorporate ESG criteria into the investment process. For example, during FY18 AllianzGI engaged with Unilever following its proposal to incorporate the company solely in the Netherlands, abandoning its UK listing; the plan was ultimately withdrawn.

BUT’s portfolio typically holds c 70 stocks selected from an investible universe of around 2,300 companies. Turnover in FY18 was relatively low at 13.9%, which implies a seven-year holding period; the manager typically aims to hold positions for at least three to five years.

While Macdonald invests on a bottom-up basis, unconstrained by benchmark weightings, it is interesting to note BUT’s geographic and sector breakdown (Exhibits 3 and 4). The trust’s exposure to the key North American market has increased over the past year and is broadly in line with the composite index. It has an overweight position in continental Europe, with underweight exposures to the UK and Asia.

While financials make up around a fifth of BUT’s portfolio, its largest overweight bets are in industrials and healthcare, with meaningful underweights in both the consumer services and consumer goods sectors.

In early 2019, Macdonald took the opportunity to add to positions in the portfolio that had pulled back and which are beneficiaries of China’s long-term growth potential, such as Taiwan Semiconductor Manufacturing Company, German industrial firm Schneider Electric, pan-Asian life insurance company AIA and Itochu, one of Japan’s largest trading companies. The manager notes improvements in China’s recent purchasing manager indices and is encouraged by the government’s significant fiscal and monetary stimulus, along with robust infrastructure spending in the country; she is expecting more evidence of an improving Chinese economy in coming months.

Macdonald highlights a few of BUT’s newer positions:

Intuit – a US company, primarily providing tax and accounting software. The manager says Intuit is a high-quality firm operating in an oligopolistic market. It suffered margin compression while rolling out its online operations, which caused a de-rating of its shares. Now the majority of Intuit’s business is online, margins are improving and growth is accelerating. This is currently a small position in the portfolio as the manager is looking to add exposure on share price weakness.

Assa Abloy – a Swedish lock manufacturer with broad end markets. Macdonald explains that the company is benefiting from a shift to digital products and a higher volume of service revenues, both of which are margin enhancing. She says the company is high quality, with a good percentage of recurring revenues. This too is a small position that the manager will look to add to opportunistically.

St James’s Place – a UK financial services company whose stock price had de-rated on the back of Brexit concerns and fears about a Labour government coming to power. St James’s Place charges higher fees compared with other platforms such as AJ Bell, but its high brand value ensures that it has a ‘sticky’ client base. The company is growing rapidly, helped by the increased requirement for individuals to save more and look after their own pensions. Longer life expectancy means that there is increased demand for higher-margin growth assets, which are held for longer, thus generating a larger fee stream.

In recent months the manager has been selling lower-conviction holdings such as CME (an expensive holding received as part of the proceeds from the NEX takeover); Apple (facing increased competition in its high-margin handset operations); and Walgreens Boots Alliance (operating in a more challenging environment; the position was sold ahead of a recent profit warning, which caused a greater than 10% fall in its share price).

Over the last three, five and 10 years BUT has generated NAV total returns between 10.5% and 15.1% pa and share price total returns between 11.1% and 16.1% pa.

Macdonald comments on more recent performance, noting positive contributors include three US companies: analytical laboratory instrument manufacturer Agilent Technologies; Ecolab, which is a provider of water, hygiene and energy technologies and services; and beauty product company Estée Lauder. One holding that has detracted from performance is major US healthcare company UnitedHealth. Although it was one of the fund’s best-performing positions last year, the sector has been under some pressure recently due to political concerns. However, the manager believes that the company will be a long-term beneficiary as the US strives to lower its burgeoning healthcare costs. While all stock markets have rallied so far 2019, BUT’s North American exposure has lagged the performance of the US market due to its underweight position in highly rated technology stocks, which tend not to pay a dividend. Macdonald explains that there is a much higher bar for lower-yielding stocks to gain a place in BUT’s portfolio.

BUT’s relative returns are shown in Exhibit 7. While lagging the benchmark over one year, its NAV total return is higher than the benchmark total returns over three, five and 10 years. The trust has modestly outperformed the FTSE All-Share index over one year, but has significantly outperformed over three, five and 10 years in both NAV and share price terms, illustrating the potential benefits of investing in overseas companies.

BUT’s share price discount to NAV narrowed meaningfully between late 2016 and late 2017, perhaps in anticipation of the trust’s repayment of its high-cost debenture in January 2018 (see Capital structure and fees section below), while marketing in the private retail investor space has increased. It now consistently trades around a 10% discount to cum-income NAV. Its current 11.1% discount compares with the 6.1% to 13.0% range over the last 12 months. Over the last one, three, five and 10 years, the trust has traded at average discounts of 10.3%, 12.4%, 12.5% and 12.6% respectively. There is potential for a narrower discount over time, given BUT’s simplified capital structure, and if Macdonald can build on her record of outperformance.

BUT is a conventional investment trust with 42.7m ordinary shares in issue. The trust has significantly improved its capital structure in recent quarters. In January 2018, its £18.2m high-cost (11.27%) debenture was paid off using cash reserves and in June 2018, BUT redeemed another £28m high-cost (9.25%) debenture due in May 2023, at a total cost of £39.4m (including accrued interest). The repayment was funded by the issue of a £25m fixed-rate, 30-year loan note at a record low rate for long-term financing (2.84%), plus existing cash and bank debt. BUT also has a £10m short-term revolving credit facility to provide portfolio management flexibility and £0.5m of 5% cumulative preference shares. The refinancing initiatives have significantly reduced the trust’s weighted average interest costs on its structural borrowings to c 3.0%, increasing the potential for dividend growth. As at end-March 2019, BUT had net gearing of 7.9%.

AllianzGI is paid an annual management fee of 0.45% of BUT’s net assets minus short-term liabilities, excluding any funds managed by AllianzGI. In FY18, ongoing charges were 0.66%, 6bp lower than 0.72% in FY17.

BUT has a distinguished dividend history, increasing its annual distribution for 47 consecutive years. Over the period, the trust’s annual dividend has grown at a significantly higher rate than UK inflation. In FY18 (ending 30 November) BUT generated earnings per share of 19.7p per share, 7.1% higher than 18.4p in FY17, while the 18.15p total distribution (1.1x covered) was an increase of 10.0% year-on-year. This growth in the dividend compares very favourably with the 3.2% rise in the Retail Price Index over the period. Revenue reserves following the payment of all four FY18 quarterly dividends are 26.9p (c 1.5x the last annual dividend). BUT pays quarterly dividends in June, September, December and March and currently offers a 2.3% dividend yield.

Exhibit 9 shows the nine funds in the AIC Global sector with 15% to 45% UK exposure. BUT’s NAV total returns (with debt at par value) are below average over the periods shown. It has the second-largest discount in the selected peer group, a higher-than-average level of gearing, and the fifth-highest dividend yield, which is in line with the average.

Macdonald comments that some of BUT’s peers are more focused on capital growth than on both capital and income growth. She says that when markets weaken, BUT’s relative performance versus its peers tends to improve due to its lower beta. The manager argues that BUT would be equally at home in the AIC Global Equity Income as the Global sector.

There are five independent, non-executive directors on BUT’s board. The chairman is Carolan Dobson who was appointed as a director in December 2013 and assumed her current role in March 2016. She is also chairman of Baillie Gifford UK Growth Fund, BlackRock Latin American Investment Trust and JP Morgan European Smaller Companies. Vivian Bazalgette is the senior independent director and chairman of the remuneration committee; he joined the board in January 2004. Ian Barlow is chairman of the audit committee and was appointed as a director in November 2009. The other two directors and their dates of appointment are Peter Maynard (October 2010) and Jim Sharp (January 2014 – he is connected to the Brunner family by marriage).

The board is planning for the future and has committed to refreshing its composition in the next few years; Bazalgette has announced his intention to retire later in 2019, while Barlow has agreed to stay on the board until late 2020.