Foreign & Colonial Investment Trust — Distinguished dividend history

Exhibit 2 (left-hand side) shows the meaningful outperformance of global versus UK equities over the last five years. Over the last several months, UK investors in overseas equities have benefited from sterling weakness. In general, equities have rallied strongly following stock market corrections in early 2016; this re-rating has led to equity valuations looking less attractive. On a forward P/E multiple basis, some developed markets such as Europe, the UK and the US are trading at a c 20% premium to their averages of the last 10 years (Exhibit 2, right-hand side). For investors seeking long-term growth in capital and income, a well-established fund investing in a range of asset classes, including an allocation to regions where valuations are less extended, such as Japan and emerging markets, may be of interest.

FRCL was launched in 1868, so is approaching its 150th birthday; it is the oldest collective investment fund in the world. The trust has a progressive dividend policy and in FY17 is on track for its 47th consecutive annual dividend increase. FRCL has been managed by Paul Niven since July 2014; he is only the third manager of the trust since 1969. Niven aims to generate long-term growth in capital and income and attractive risk-adjusted returns from a globally diversified portfolio of listed equities, unlisted securities and private equity. Since 1 January 2013, FRCL has been benchmarked against the FTSE All-World index, rather than a composite of the FTSE World ex-UK and FTSE All-Share indices, reflecting a lower weighting to UK equities. There are no specific geographic or sector limits for listed equities. Up to 5% of the portfolio, at the time of acquisition, may be directly invested in unlisted securities, which require specific board approval. No single investment may exceed 10% and a maximum 5% may be in investment funds managed by BMO Global Asset Management, which also requires board approval. Shareholder approval would be required if long-term exposure to private equity were to exceed 20%. Gearing of up to 20% of NAV is permitted; at end-July 2017 net gearing was 7.0%.

The manager says that H117 was a good period for risk assets in general, including multiple new stock market highs in both the US and the UK. He suggests that the largest macro surprise was moderating inflation in the US, which led to bond yields falling as interest rate rise expectations lessened. He says that six to eight months ago, the general belief was that the global outlook for 2017 was for higher inflation and higher interest rates. While there has been a synchronised global economic recovery, he believes that the reflation trade in the stock market is over, evidenced by weakness in energy stocks year to date. In the US there are only two out of 11 sectors that are underwater in 2017 and energy is the weakest performing area. However, although the euphoria following President Trump’s election in late 2016 appears to have run its course, stock markets are continuing to move higher in response to better than expected corporate earnings.

Niven comments that generally assets are expensive, including equities, bonds and private equity. He says that there is a lot of ‘dry powder’ (cash awaiting investment) in the private equity space and a lot of bullishness surrounding the asset class. The manager says that several large investment houses have raised a phenomenal amount of capital and so are looking for ‘big-ticket’ investments. He believes that there are better private equity valuations further down the market cap scale, the area where FRCL is targeting its private equity direct investment.

Niven aims to generate long-term growth in capital and income from a broad portfolio that is diversified by geography and sector. He is benchmark aware, but does not follow the FTSE All-World index allocations. FRCL is constructed with inputs from both BMO’s specialist teams and third-party managers, which undergo regular formal reviews. Historically, private equity exposure was achieved via HarbourVest and Pantheon funds of funds, providing global exposure across sectors and vintage years. However, current and future investments are made directly in primary and secondary funds as well as co-investments. During H117, FRCL continued its more focused and opportunistic investment approach towards private equity investments with £23.8m in new commitments. As existing fund-of-fund investments are run off, there will be significant savings in agency fees; in 2016, FRCL paid £4.6m to HarbourVest and Pantheon. The manager highlights that FRCL’s diversified investment approach not only reduces risks, but generates lower volatility of investment returns versus its peers, which is helped by its private equity exposure.

While the number of holdings in Exhibit 3 totals c 550, given FRCL’s fund and private equity holdings, the number of underlying companies runs into the thousands. The manager notes the lower than average active share in the UK strategy and says that this will increase over time. In terms of geographic exposure, FRCL’s regional weightings are broadly similar to end-2016 (with the exception of 1.0pp higher exposure to emerging markets), with overweight positions in Europe ex-UK, emerging markets, Japan and UK and underweight positions in the North American region, where the manager considers that US equity valuations are relatively unattractive, and the small developed Pacific region, where he finds the large commodity exposure and equity valuations unappealing. The manager says the overweight position in the UK is due to the dominance of multinational companies that generate the majority of their earnings overseas; he is more bearish on the UK economy than the UK stock market, and says that over time the UK allocation will likely decline, as he considers that there are better investment opportunities elsewhere.

Absolute returns are shown in Exhibit 5.Over the past 12 months, sterling weakness has enhanced the value of overseas assets for UK-based investors. Over this period, FRCL’s NAV and share price total returns of 21.4% and 26.2% are meaningfully ahead of the benchmark’s 19.7% total return.

In H117 ending 30 June 2017, FRCL’s NAV and share price total returns of 9.1% and 8.7% respectively were comfortably ahead of the benchmark’s 6.3% total return. Most regional strategies outperformed their respective indices, including emerging markets (+6.2pp, which also generated the highest returns of 18.9%) and the US (+3.1pp). The European strategy returned 12.7%, which was just 0.1pp behind its regional benchmark. From an asset allocation perspective, overall investment performance was boosted by underweight exposure to the US as the dollar declined by c 4% on a trade-weighted basis. The 7.4% exposure to private equity detracted from performance given that assets are valued with a three-month lag and equity markets rallied over the period.

FRCL’s relative returns are shown in Exhibit 6. Following improved recent performance, the trust’s NAV total return is now ahead of the benchmark over three years and most of the shorter periods shown. It is modestly behind the benchmark over five years and ahead over 10 years. Over one, three, five and 10 years FRCL’s share price total return is higher than its NAV total return, which has resulted in a narrower discount over time. For UK-based investors, it is interesting to highlight its significant outperformance versus the FTSE All-Share index over one, three, five and 10 years.

FRCL’s current 5.8% share price discount to cum-income NAV is narrower than the 8.1% average of the last 12 months (range of 5.0% to 11.3%, which occurred during a period of uncertainty ahead of the US presidential election). The discount is also narrower than the averages of the last three, five and 10 years of 8.4%, 9.2% and 9.4% respectively.

FRCL’s board actively manages the discount by purchasing shares when the discount exceeds 7.5% in normal market conditions. This policy was changed in May 2015, before which the board targeted a 10.0% discount; it aspires to a discount narrower than 7.5% over time. The manager comments that the rate of share repurchases is much lower than in 2016, but is ongoing (Exhibit 1).

FRCL is a conventional investment trust with one class of share; there are currently 542.9m ordinary shares in issue, with a further 19.0m held in treasury. Gearing of up to 20% of NAV is permitted; at end-July 2017 it was 7.0%, which is towards the low end of the historical range. FRCL has a range of borrowing arrangements diversified by currency, lender and maturity profile; this includes a £100m short-dated revolving credit facility with a £100m accordion feature, which provides flexibility and reduces refinancing risk. At end-H117, the trust’s weighted average cost of debt was c 2.8%. This is considerably lower than the 7%+ cost in 2014 before the maturity of an 11.25% longstanding debenture. FRCL’s debt profile is as follows: ¥6.6bn at 2.50% and $80m at 4.00% maturing in 2019; €72m at 1.69% in 2022; £25m at 2.80% in 2028; £50m at 3.16% in 2031 and a £0.6m 4.25% perpetual debenture. The manager says that he thought borrowing rates looked attractive 12 months ago, but they have since become even more so, while spreads are also tighter than a year ago.

BMO Global Asset Management is paid an annual management fee of 0.365% of market cap, and FRCL also pays direct fees to its external managers. The manager believes that the trust’s fee structure is competitive with its peers, especially given that part of the asset management function is outsourced. The ongoing charge in FY16 was 0.79%, broadly similar to 0.80% in FY15, and includes agency fees paid to private equity managers, which are expected to decline going forward.

FRCL has a distinguished dividend history. The board has announced its intention to grow the annual dividend again in FY17; this will be the 47th consecutive year. It aims to increase dividends in real terms and, over the last 10 years, the dividend has compounded at an annual rate of 6.4%, which is significantly higher than the UK inflation rate over the period.

In FY16, the annual dividend was 9.85p, which was 2.6% higher than the previous financial year and higher than the 1.6% rise in the Consumer Price Index. The FY16 dividend was fully covered by income and at the year-end, FRCL’s revenue reserve was c 1x the annual dividend. The trust’s current dividend yield is 1.6%.

FRCL is a member of the AIC Global sector. In Exhibit 8 we highlight the peers with less than 25% exposure in the UK. With a market cap above £3bn, FRCL is the second largest trust in the selected peer group. Its NAV total returns are below the weighted average over the periods shown; however, it should be noted that the average is skewed by the largest trust, Scottish Mortgage, which has the highest total returns over all periods shown. In addition, the manager comments that some of the peers have particular investment biases, which has led to better relative performance. FRCL ranks tenth, sixth and sixth out of 16 funds over one, three and five years respectively, and ranks fifth out of 15 funds over 10 years.

Within the selected peer group there is a wide range of discounts; FRCL’s is modestly above the weighted average. Its ongoing charge and gearing are broadly average, but FRCL has an above-average dividend yield, 0.3pp higher than the weighted average.

Following the retirement of Stephen Burley at the April 2017 AGM after nine years’ service, there are currently seven directors on the board of FRCL; all are non-executive and independent of the manager. Chairman Simon Fraser was appointed in September 2009 and has held his current role since May 2010. Senior independent director Sir Roger Bone was appointed in March 2008; Jeffrey Hewitt in September 2010; Sarah Arkle and Nicholas Moakes in March 2011; Francesca Ecsery in August 2013; and Edward Knapp in July 2016. On 25 July 2017, the board announced the appointment of another independent, non-executive director, effective 1 September 2017 – Beatrice Hollond has a background in asset management and is currently on the boards of Brown Advisory, Telecoms Plus, M&G Group, Henderson Smaller Companies Investment Trust and Templeton Emerging Markets Investment Trust. Hollond is also chairman of Millbank Investment Managers and Keystone Investment Trust.