The Brunner Investment Trust — Dividend increased for 45 consecutive years

Exhibit 2 (left-hand side) shows the performance of UK and world equities over the last 10 years. 2016 was a period of above-average global equity returns and the value of overseas equities was enhanced for UK investors by the depreciation of sterling. Investors shrugged off significant macro events such as the UK’s European referendum and the US presidential election; equities rallied meaningfully, leading to a positive re-rating. As shown in Exhibit 2 (right-hand side), global equities (measured by the Datastream World Index) are now trading near the top end of their 10-year forward P/E range and c 20% above the 10-year average. While equities are currently supported by more robust earnings growth, there are further macro uncertainties in 2017, such as forthcoming European elections and the pace and magnitude of further US interest rate rises. For investors wanting exposure to global equities, a relatively concentrated fund aiming for long-term growth in both capital and income, with a longstanding history of increasing dividends, may be of interest.

BUT was launched in 1927 as an investment vehicle to manage the wealth of the Brunner family following the sale of Brunner Mond & Co, which was the largest of four companies that combined to become Imperial Chemical Industries. The Brunner family continues to be BUT’s largest shareholder. Since 23 June 2016, BUT has been solely managed by Lucy Macdonald; prior to this, she was co-manager with Jeremy Thomas. The trust aims to generate long-term growth in capital and income from a portfolio of global equities. On 22 March 2017, BUT’s benchmark was changed from 50% FTSE All-Share and 50% FTSE World ex-UK indices to 70% FTSE World ex-UK and 30% FTSE All-Share indices. At the time of investment, the maximum holding in a single asset is 10% of gross assets and to ensure adequate diversification, the portfolio must hold at least 50 stocks. Gearing is employed with the aim of enhancing returns over the long term; up to 20% of net assets is permitted. Annual dividends have increased regularly for the last 45 consecutive years.

The manager suggests that in 2017, equities are likely to deliver nominal returns more in line with historical levels, unlike in 2016, which was a year of outsized returns with the value of UK shareholders’ overseas equities boosted significantly by sterling weakness. Global earnings growth has been improving since Q316, which should be supportive for equity prices following a period of positive revaluation in recent months. However, Macdonald opines that overall debt levels are a constraint to economic growth, which will make it difficult to move corporate earnings growth up to a higher growth trend. Given elevated valuations and current low stock market volatility, BUT’s gearing is towards the low end of its normal 5-15% range. The manager suggests that forthcoming macro events have the potential to lead to higher stock market volatility; these include European elections, the impacts of Brexit, changing US policy and the recent downturn in the oil price, which brings into question the sustainability of the earnings recovery in the energy sector. If the stock market were to sell-off, the manager suggests that she is likely to put cash to work in attractive opportunities.

Macdonald comments that there have been some consistent messages from recent company meetings and Q416 earnings reports. There are signs of cost inflation in the UK as a result of the weakness in sterling, higher commodity prices and some wage pressure due to minimum wage legislation and a low level of unemployment. So far, margins have held up, but the manager suggests that this is an area to watch going forward. A lot of companies have voiced concerns about the political environment, which is affecting their capex decisions. The manager comments that confidence is high in the US corporate sector, but overall global growth is patchy.

The manager suggests that overall dividend trends are healthy. There has been an earnings recovery in the financial sector as a result of higher interest rates, and the potential for less onerous US financial regulation is also a positive for this sector’s dividends. Repatriation of US companies’ overseas capital at lower tax rates appears more likely under a Trump administration, which could lead to higher dividends as well as an increase in merger and acquisition (M&A) activity. Global deal activity has been robust over the last two years, but is below peak levels; along with earnings growth, a higher level of M&A should also be supportive for equity valuations.

Manager Lucy Macdonald invests on a bottom-up basis, with an awareness of the macro environment. She undertakes in-depth fundamental research, aiming to select stocks and construct a portfolio that can generate long-term growth in capital and income, with a balance in style between growth and value companies – potential investments are screened to determine their style characteristics and upside potential. Over time, the portfolio has become more concentrated; the current c 75 holdings compares to c 100 in 2013 (and may be reduced further over time), and there is a higher weighting to global equities, allowing more diversified potential capital and income growth and access to higher growth in dividends. When BUT was co-managed, it comprised two portfolios: UK equities (managed by Thomas) and overseas equities (managed by Macdonald). The UK stock selection process was very value driven; since the move to a sole manager in June 2016, Macdonald has been moderating the UK stock selection process, improving the quality of stocks purchased for the portfolio. She looks for companies that generate high returns, have strong, experienced management teams and robust balance sheets, while trading on reasonable valuations. The manager is able to draw on the resources of her colleagues at AllianzGI – all of BUT’s UK holdings are also included in The Merchants Trust (managed by Simon Gergel) or the Allianz UK Unconstrained Fund (managed by Matthew Tillett).

As shown in Exhibit 1, at end-February 2017, BUT’s top 10 positions accounted for 21.4% of the portfolio; this was broadly in line with 22.0% at end-February 2016, and seven holdings were common to both periods. Exhibit 3 shows BUT’s geographic breakdown to end-February 2017; exposure to the UK has continued to decline, with Europe ex-UK having the largest increase in exposure over the last 12 months.

Exhibit 4 shows BUT’s sector exposure to end-February 2017. The largest increases are in technology and industrials, which the manager comments have been made on a very stock-specific basis. Recently, Macdonald has been adding to the healthcare sector as there is more clarity about the repeal of Obamacare, and industry valuations remain attractive despite the overhang of a potential Clinton presidential election win being removed. The industry focus within the US healthcare sector is on bringing costs down; BUT has a large position in UnitedHealth, a large US healthcare services company with diverse operations that is increasingly using technology to deliver more effective solutions for patients and healthcare providers. The manager has been reducing cyclical exposure within the portfolio: within basic materials, the BHP Billiton position was sold, while within oil & gas, holdings in EOG Resources and Total have been reduced.

A recent addition to the BUT portfolio is Celgene, a major US biotech company. Its Revlimid drug is being used for the treatment of multiple myeloma; while not a new drug, growth has been strong. The manager suggests that Celgene’s earnings growth profile is attractive and it has an underappreciated product pipeline. She comments that concerns about drug pricing in the US have led to attractive valuations within several areas of the diverse US healthcare industry.

Two other new positions in BUT’s portfolio are Tencent and Wabtec. Tencent is China’s leading internet services portal, with revenue growth of c 30% per year; it was purchased on weakness following a shift in global stock markets in late 2016, when investor preference shifted from growth to cyclical stocks. Wabtec provides products and services for the global rail industry. This includes automatic braking systems for trains, which are now mandatory in the US and Europe. A cyclical recovery in freight volumes should lead to higher demand for Wabtec’s product offering and it recently acquired Faiveley, which brings geographic and product diversity and potential cost synergies, which the manager considers are not reflected in Wabtec’s current share price.

Absolute returns are shown in Exhibit 5 (right-hand side) – over the last 12 months, BUT’s overseas holdings have been boosted by the weakness in sterling.

BUT’s relative returns are shown in Exhibit 6; its NAV total returns have outperformed the benchmark over one and five years, while lagging over three and 10 years. Given its exposure to overseas stocks, which have performed better than UK stocks, BUT has outperformed the FTSE All-Share Index over one, three, five and 10 years in both share price and NAV total return terms.

The manager comments that she is particularly pleased that the performance of the fund has held up following a style shift in the global stock markets from growth to value at the end of 2016 (Exhibit 7). She suggests that this illustrates the benefits of having a balance in the portfolio between growth and value stocks. Since the switch to a sole manager in June 2016, BUT’s relative performance has benefited from stock selection in both overseas and UK stocks.

BUT’s shares are currently trading at a 12.6% discount to net asset value (Exhibit 9, cum-income with debt at fair value). This is narrower than the 16.3% average of the last 12 months (range of 10.6% to 20.8%); it has been in a near-term narrowing trend since December 2016. The discount is broadly in line with the averages of the last three, five and 10 years of 13.8%, 13.6% and 13.0%, respectively. It is reasonable to suggest that the discount should begin to narrow as the January 2018 maturity date of BUT’s first tranche of high-cost debt approaches (see following section).

Given BUT’s structural gearing, it is sensible to consider the discount with debt at par value (currently 14.3%, Exhibit 8); this tends to be higher than with debt at fair value as the market value of the debt is higher than the par value.

BUT is a conventional investment trust, currently with 42.7m ordinary shares in issue. It has structural gearing of c £50m, which is relatively high cost compared to prevailing low interest rates: an £18.2m stepped interest rate loan (effective rate of 11.27% due 2 January 2018), a £28.0m fixed-rate loan (9.25% due 20 May 2023) and £0.5m of 5% cumulative preference stock. As the first maturity date approaches, BUT’s discount should narrow (it has cash available to pay off the debt); the maturity will provide BUT with more flexibility and remove a financial drag. The board regularly discusses options for the remaining high-cost debt.

AllianzGI is paid an annual management fee of 0.45% of net assets less short-term liabilities and excluding any funds managed by AllianzGI. In FY16, ongoing charges were 0.78%.

Since FY14, BUT has paid dividends quarterly in June, September, December and March. It has a progressive dividend policy and annual dividends have increased for 45 consecutive years. Over the last five years, the dividend has compounded at an annual rate of 4.3%. The FY16 annual dividend of 15.8p was 3.3% higher than the prior year and was 1.04x covered by earnings; BUT’s current dividend yield is 2.3%.

BUT is a member of the AIC Global sector. In Exhibit 10 we show the trusts in this sector that have between 20% and 50% exposure to the UK. BUT’s improving near-term performance is demonstrated in its one-year total return, which is above the peer group average, ranking fifth out of 10 funds. BUT’s NAV total return lags the averages over three, five and 10 years. Its discount is the widest in the group, perhaps reflecting its high-cost debt. BUT’s ongoing charge is modestly above average, although no performance fee is payable. Its gearing is broadly in line with the average, but its 2.4% dividend yield is 60% higher than average, ranking third in the group.

There are five directors on the BUT board; all are non-executive and independent of the manager. Chairman Carolan Dobson was appointed in December 2013 and assumed her current role in March 2016. The other board members and their dates of appointment are: Vivian Bazalgette, senior independent director (January 2004); Ian Barlow (November 2009); Peter Maynard (October 2010); and Jim Sharp (January 2014).