Brunner Investment Trust (The) — Focused global equity exposure

As shown in Exhibit 2 (LHS), this year has seen a return to more normal levels of stock market volatility following a particularly benign period in 2017. Investors are becoming more discerning, given an uncertain macro backdrop due to trade tensions and central banks moving towards a more normal monetary environment. While corporate earnings growth remains robust, estimate revisions are looking less positive than in recent quarters and, despite near-term share price weakness, on a forward P/E multiple basis global equities are still trading at a premium to their 10-year average (Exhibit 2, RHS). Taking these factors into consideration, investors may benefit from a focus on well-researched, high-quality companies that are able to thrive in their respective industries.

BUT was launched in 1927 to manage the wealth of the Brunner family, which still owns c 30% of the shares (Exhibit 1). The trust is a global, actively managed equity fund seeking capital and dividend growth. BUT has a 46-year record of real (above the level of UK inflation) dividend growth. Since June 2016, it has been managed solely by Lucy Macdonald, chief investment officer for global equities at Allianz Global Investors (AllianzGI), who works closely with UK fund manager Matthew Tillett. She has increased the fund’s concentration and active share (now c 85%). Previously, BUT had two lead managers, each running a distinct pool of assets: a UK equity and an overseas equity portfolio. The trust is now benchmarked against a composite measure of 70% FTSE All-World ex-UK and 30% FTSE All-Share indices (previously 50:50). This year, key developments have included the repayment of BUT’s two high-cost debentures, which have been replaced with significantly cheaper debt, resulting in a much more straightforward capital structure and increased financial flexibility. To ensure adequate diversification of risk, the trust’s portfolio must contain at least 50 holdings, spread by geography and sector; at the time of investment, a maximum 10% may be in a single position. Gearing of up to 20% of NAV, at the time of borrowing, is permitted; net gearing was 6.8% at end-September 2018.

Macdonald says that in terms of her outlook for global stock markets at the start of the year, 2018 is playing out as expected. A decade on from the global financial crisis, it appears that liquidity, earnings growth and equity valuations have peaked, which suggest more modest share price total returns going forward. In this environment, Macdonald believes that successful stock picking will be key to generating an adequate return for investors.

Share prices have been buoyed in recent years by ample liquidity. However, this looks to have peaked in the US, where the Federal Reserve has moved away from quantitative easing, and investors are now increasingly concerned about the pace and magnitude of US interest rate rises. Macdonald believes that liquidity has been a critical support for asset prices in recent years, so will be the most important factor for equity returns as it is withdrawn. She also notes that US earnings growth in 2018 has been very strong (c +20%) because of tax reform, the benefits of which will diminish in 2019. While earnings growth was particularly strong in H118, the manager says that the negative effects of the US’s protectionist trade policies are now starting to affect corporate earnings.

In terms of valuation, looking at the cyclically adjusted P/E ratio, multiples remain high. Macdonald says that as interest rates normalise, equity valuations are likely to decline, leading to a less exciting period for asset prices. She believes that quality companies will outperform the broader stock market, and firms with low levels of debt should do relatively better in a rising interest rate environment. The manager argues that value stocks in general do not look particularly attractive, and that many cheaper companies are ‘cheap for a reason’, such as those in the telecom sector.

Lead manager Macdonald selects stocks on a bottom-up basis, while taking account of the macro environment, aiming to generate long-term growth in capital and income. She is able to draw on the very deep resources of AllianzGI’s investment team, which includes a global network of fund managers and analysts. Along with fundamental company research, team members focus on the macroeconomic background; systematic research; environmental, social and governance (ESG) factors; and AllianzGI’s proprietary Grassroots market research. All of the investment team have access to Salesforce Chatter, an online investment discussion platform, which Macdonald describes as a very important, vast resource for sharing and debating investment ideas across geographies and industries.

Grassroots is a non-financial research function, used to complement financial and ESG research. It is used to investigate specific elements of the investment case. Resources include 10 internal staff, 61 reporters and more than 50,000 industry contacts. An example of a Grassroots case study relates to BUT’s holding in Richemont, where the team investigated Chinese watch inventory levels following a downturn in the luxury goods market. The team determined that there was strong underlying demand for premium watches, led by consumers trading up and a shrinking price gap between high-end watch prices in China and abroad. Another investigation centred on kitchen supplier Howden Joinery, whose share price fell following the UK’s EU referendum in 2016. The company has quality and growth attributes, with a high market share in the trade channel. The Grassroots survey showed that Howden’s fundamentals remained strong, and that it was continuing to increase market share despite a weak operating environment.

Over time, BUT’s portfolio has become more concentrated. It currently holds 65 positions, filtered down from an investible universe of c 2,300 companies. This compares with c 100 holdings in 2013, and the trust now has a higher exposure to overseas equities. Macdonald seeks reasonably priced companies with strong fundamentals, robust balance sheets, and a well-respected management team. She aims to generate excess returns of 2-3% pa on a three- to five-year view.

The trust’s geographic exposure is shown in Exhibit 3. The largest increase in 12 months to end-September 2018 was +9.1pp in North America, where BUT is now modestly overweight compared with the composite benchmark; the manager is also maintaining a meaningful overweight exposure to continental European equities (+11.0pp). UK exposure continues to decline, but remains above 25% of the portfolio as BUT holds some higher-yielding stocks such as HSBC, BP and Royal Dutch Shell, which contribute towards the trust’s dividend payments. However, the manager notes that there is now a greater number of dividend yield and dividend growth opportunities in overseas markets compared with history. As a result, over time, BUT’s higher-yielding UK positions may be reduced, with the proceeds recycled into higher-growth overseas companies.

The trust’s sector exposure is shown in Exhibit 4. There have been modest changes over the last 12 months, with higher weightings to the technology (+2.4pp) and healthcare sectors (+2.1pp) and a lower weighting to the industrials sector (-3.1pp).

Macdonald is continuing to increase the quality/concentration of BUT’s portfolio. Recent complete disposals include higher-yielding UK telecom stock Vodafone and lower-quality UK financial services company IFG Group, along with Chinese conglomerate Tencent, which had performed particularly well, and UBM, which was taken over by UK publishing and events company Informa.

A strong theme in the portfolio is technological change, which is prevalent across a range of sectors. Macdonald and her team focus on companies that are adapting their businesses to thrive in a world of increased digitisation; those firms that can successfully change are seeing benefits in terms of incremental revenues and lower costs. The manager explains that in a digital age, a company’s annual report is becoming less useful as a guide to the underlying value of a firm’s assets or the costs incurred when doing business. She says that AllianzGI’s deep resources mean that its fund managers and analysts are able to gain a deeper understanding of a company’s changing business model. As an example, BUT has a position in US laboratory instrument firm Agilent, which is investing for its future in a digital world. Because of the cost of this increased capex, its earnings are currently depressed. However, Macdonald is confident in the company’s long-term growth prospects.

Exhibit 6 shows BUT’s relative performance. Its NAV total return is ahead of the benchmark over three and five years, while lagging over one and 10 years, and its share price has outperformed the benchmark over three, five and 10 years. For UK investors, it is interesting to note BUT’s much higher total returns in both NAV and share price terms compared with the FTSE All-Share index over three, five and 10 years, illustrating the potential benefits of investing in overseas rather than UK equities.

While BUT’s relative and absolute share price and NAV performance has struggled in recent months (Exhibit 5), a period which has been characterised by higher stock market volatility, Macdonald has outperformed the benchmark by c 2.5pp since becoming sole manager on 23 June 2016 (Exhibit 7).

Following the restructuring of BUT’s high-cost debt, its discount with debt at market value is now broadly similar to its discount with debt at par (Exhibits 8 and 9). Its current 11.1% share price discount to cum-income NAV (with debt at market value) compares with the 9.9% to 12.8% range of averages over the last one, three, five and 10 years. There is scope for BUT’s discount to narrow given its simplified capital structure may hold greater investor appeal, and if Macdonald is able to build on her record of outperformance versus the benchmark since becoming sole manager.

BUT is a conventional investment trust with one class of share; there are 42.7m ordinary shares in issue. The trust historically had a significant amount of high-cost debt, which was taken on when interest rates were much higher than current levels. A c £18m, 11.125% stepped interest rate loan was repaid on the 2 January 2018 maturity date, and the £28m, 9.25% fixed-rate loan with a 2023 maturity date was repaid early, in June 2018. While there was a modest 0.7% reduction in BUT’s NAV as a result of the early repayment, the board considered this was outweighed by the advantages of lowering the trust’s interest repayments, boosting dividend cover, and making its capital structure much more straightforward. It took advantage of prevailing low interest rates to take out a £25m, 30-year private placement note with a coupon of 2.84%. BUT also has a £10m, short-term revolving credit facility, to provide additional flexibility when required, along with £0.5m of 5% cumulative preference shares. The board believes that global equity markets should be able to generate a total annual return well in excess of 2.84%, so the debt refinancing will have long-term benefits for BUT’s shareholders. At end-September 2018, the trust had net gearing of 6.8%.

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. The ongoing charge in FY17 was 0.72%, which was 6bp lower than in FY16.

BUT’s chairman says that the board works very hard to plan for real dividend growth, and the annual distribution has increased for the last 46 consecutive years. So far in FY18, three interim dividends of 4.05p per share have been declared. The board anticipates that, barring unforeseen circumstances, the final dividend will be 6.00p (in line with FY17), which will mean a total dividend of 18.15p for FY18 (+10% versus 16.50p in FY17, and a five-year compound annual growth rate of 4.6%). Any excess revenues are added to reserves, which stood at £15.4m (c 3.5p per share) at end-H118. Based on its current share price, BUT offers a dividend yield of 2.5%, which is above the average of its peers (Exhibit 10).

In Exhibit 10, we show the funds in the AIC Global sector with UK exposure between 15% and 45%. BUT’s NAV total returns, with debt at par value, are below average over the periods shown. Its discount remains one of the widest in the selected peer group, despite its simplified capital structure. Gearing is broadly average, while the trust has an above-average yield, ranking third.

BUT’s board has five non-executive, independent directors: Carolan Dobson (chairman since March 2016, and appointed to the board in December 2013), Vivian Bazalgette (senior independent director, who joined the board in January 2004), Ian Barlow (appointed in November 2009), Peter Maynard (appointed in October 2010) and Jim Sharp (appointed in January 2014).