Foreign & Colonial Investment Trust — Update 7 December 2016

As shown in Exhibit 2 (right-hand side), despite the near term increase in bond yields, the income available from investment in equities remains attractive versus investment in bonds. While the valuations of world equities are generally above their long-term averages – the forward P/E multiple is towards the top end of the range and 15% above the 10-year average, and the price-to-book ratio is 10% above the 10-year average – the outlook for economic growth remains favourable. In its October 2016 World Economic Outlook, the International Monetary Fund maintained its outlook for global growth in 2016 and 2017 of 3.1% and 3.4% respectively, with advanced economy growth of 1.6% and 1.8% versus emerging market and developing economies growth of 4.2% and 4.6% respectively. In an environment of forecast accelerating growth and generally low interest rates, a diversified global portfolio focusing on both capital and income growth may be of interest to investors.

Launched in 1868, FRCL is the oldest collective investment fund in the world. With more than 100,000 investors (more than 90% retail), it is one of the most widely held investment vehicles in the UK. FRCL has 45 years of consecutive increases in annual dividends. It aims to generate long-term growth in both capital and income from an internationally diversified portfolio of listed equities, unlisted securities (maximum of 5% at time of acquisition) and private equity (board approval required above 20%). There are no specific geographic or industry sector exposure limits for listed equities, but no single investment at the time of acquisition may exceed 10% of the portfolio and a maximum of 5% may be invested in BMO Global Asset Management managed funds. Gearing of up to 20% of net assets is permitted. Derivatives may be used to enhance income or for efficient portfolio management. Prior to 1 January 2013, the benchmark was 60% FTSE World ex-UK index and 40% FTSE All-Share index; it was changed to FTSE All-World index to reflect a lower weighting to UK equities and portfolio allocation more in line with the global index. Since July 2014, FRCL has been managed by Paul Niven; he is only the third manager of the trust since 1969.

Manager Paul Niven suggests that the Trump victory in the US election is a significant event that will exacerbate existing trends. There has been a modest improvement in growth expectations and inflation has been creeping higher, which has been evident in equity markets for six to nine months and is now being reflected in bond markets. In recent years, a lot of the rerating of equities has been from the performance of bond proxies, but more recently cyclicals and financials have started to outperform after being in a bear market for several years.

The manager opines that the Trump election win suggests the rise in populism goes beyond Brexit; it has short, medium and long-term implications for Europe; politicians are likely to shift their focus from monetary to fiscal stimulus. The manager expects equities to be range bound, as although higher bond yields should put pressure on equity valuations, earnings growth is rising. He sees a higher probability of stagflation or reflation versus a continuation of the current low growth, low interest rate environment.

Niven is positive on European ex-UK equities, which have underperformed global equities so far in 2016. Global growth is improving and financial stocks are performing better. Europe has a more attractive value backdrop than the US and the manager believes that there is scope for higher earnings and margins. Although the political environment is a risk, the overall macro environment favours Europe and the manager is sticking with his overweight position. He also favours emerging markets, where exposure was increased in early 2016. Niven had watched valuations compress over the last two to three years and considered they had become attractive versus those in developed markets. Growth differentials have begun to improve; a key driver is stabilisation in Brazil and Russia. The Trump win is a near-term negative for emerging markets, but longer term the manager believes that they offer higher growth and better value than developed markets. He is heavily exposed to India, Indonesia and the Philippines, while remaining negative on China.

Commenting on recent Q316 earnings, the manager suggests they were less bad than the last five to six quarters. However, there has not been much positive forward guidance. There has been a lack of earnings growth in the US in 2015 and 2016 and both years have seen significant earnings downgrades, the magnitude of which was much bigger than in prior years. Consensus estimates for 12% US earnings growth in 2017 are considered too high given the lack of positive guidance; the manager considers that low- to mid-single digit growth is a more realistic level.

FRCL’s large, diversified portfolio is structured based on the manager’s views on the macro environment, asset allocation, risk and gearing on both a strategic and tactical level, with an objective of growth in long-term capital and income. He is benchmark aware, but FRCL does not follow benchmark allocations, an example is the c 10% exposure to private equity.

Niven constructs the portfolio with input from specialist teams both within BMO and third-party managers. Primary exposures are to regional strategies in North America (managed by Barrow Hanley and T Rowe Price), Europe (BMO), UK (BMO), emerging markets (LGM and Utilico Emerging Markets) and Japan (BMO), with three global strategies investing across these five regions: global multi-manager (BMO), global equity income (BMO) and global smaller companies (BMO). In addition, private equity exposure has historically been achieved through funds of funds with 11 HarbourVest funds and five Pantheon funds. However, future investments will be more focused and opportunistic, fully controlled by FRCL and invested into primary and secondary funds as well as co-investments. So far in 2016, £22m of new commitments have been made. As existing investments are run-off, there will be significant savings in agency fees; in 2015, FRCL paid £4.6m to HarbourVest and Pantheon.

FRCL is a widely diversified portfolio with more than 500 positions. However, taking into account the private equity and fund holdings, the number of underlying companies is in the thousands.

On a geographic basis, over the 12 months to end-October 2016, the largest increase in exposure is emerging markets, while the largest decrease is Europe ex-UK (although this remains the largest regional overweight position). FRCL continues to have a significant underweight position in North America; exposure to T Rowe Price’s US growth strategy was reduced following a period of outperformance, with the manager reinvesting the proceeds elsewhere rather than adding to Barrow Hanley’s US value strategy.

As shown in Exhibit 4 (right-hand side), absolute returns for UK-based investors have been strong in recent months, enhanced by the weakness of sterling. FRCL’s six-month share price and NAV total returns of 18.9% and 18.8% are modestly behind the benchmark total return of 21.1%.

Looking at Exhibit 6, FRCL’s NAV total return has outperformed the blended benchmark over 10 years, while lagging over shorter periods, albeit modestly over three and five years. Of interest to UK-based investors, FRCL’s share price and NAV total returns have significantly outperformed the FTSE All-Share index over one, three, five and 10 years (Exhibit 5).

FRCL actively manages the share price discount to NAV by purchasing shares with a long-term aim of having the shares trade at or close to NAV. In May 2015, the ceiling above which shares are repurchased was lowered from 10% to 7.5% (in normal market conditions). In the 11 months to end-November 2016, FRCL purchased 11.6m shares at a cost of £53.3m. There have continued to be regular share purchases in December 2016.

The current share price discount to cum-income NAV of 8.7% is broadly in line with the averages of the last one, three, five and 10 years (range of 9.1% to 9.7%). However, the averages are skewed by the period of wider discounts following the Brexit vote (the discount reached a five-year high of 14.8% on 27 June 2016).

FRCL is a conventional investment trust with one class of share; there are currently 547.0m ordinary shares in issue, with a further 14.8m held in treasury. It uses gearing with an aim of enhancing investment returns; up to a maximum of 20% of net assets is permitted. Over the last 10 years, gearing has been in a range of 4.8% in May 2007 to 18.8% in September 2011; at end-September 2016 it was 6.1%.

Following the maturity of an 11.25% long-standing debenture at the end of 2014, FRCL’s 2015 borrowing costs fell by 69% to £4.8m year-on-year. At end-2015 the blended interest rate on its debt was less than 1.7%, which is very low versus history and compares to a blended rate higher than 7% two years ago. Its current debt facilities are: £200m short dated with an additional £200m accordion; $80m and ¥6.6bn seven-year debt maturing in 2019; £50m equivalent euro loan taken out in July 2015 at a rate of 1.69%; and notes taken out in June 2016 – £12m 12-year at 2.8% and £50m 15-year at 3.16% (blended rate of 3.04%). FRCL also has a longstanding £575,000 4.25% perpetual debenture stock.

FRCL pays an annual management fee of 0.365% of net assets to BMO Global Asset Management plus direct fees paid to external managers. The manager believes that the fee structure is competitive to its peers, especially given that part of the asset management function is outsourced. The ongoing charge in FY15 was 0.80%, a 7bp decrease versus the prior year. This includes agency fees paid to private equity managers, which are expected to decline going forward (as highlighted on page 4).

FRCL has a progressive dividend policy, aiming to increase dividends in real terms; the annual dividend has doubled over the last decade, compounding at 7.3% per annum compared to an average annual UK inflation rate of 2.4%. The board intends to pay a higher dividend in 2016 versus 2015, which will mean that the annual dividend has increased for 46 consecutive years. The 2015 dividend of 9.60p was a 3.2% increase versus the prior year.

Since February 2013, dividends are paid quarterly in February, May, August and November. The board and manager are working towards ensuring that the dividend is fully covered (the 2015 dividend was c 90% covered). At H116 (June 2016), the revenue reserve was £75.1m (equivalent to 13.7p per share – 1.4x the 2015 annual dividend). FRCL’s current dividend yield is 1.9%.

Exhibit 8 shows the investment trusts in the AIC Global sector with market caps greater than £100m and less than 25% exposure to the UK. FRCL is one of the larger trusts; one of only five out of 15 with a market cap greater than £1bn.

On an absolute basis, FRCL’s NAV total returns rank seventh, fifth, third and fifth out of 15 trusts over one, three, five, and 10 years respectively. Its NAV total returns are above the weighted average for the group over one and three years and below over five and 10 years. However, the weighted average is skewed by the largest trust, Scottish Mortgage, which has the second highest NAV total return over three years and the highest over five and 10 years. When this trust is excluded, FRCL’s NAV total returns are above the peer group weighted average over one, three, five and 10 years.

In terms of risk-adjusted returns, as measured by the Sharpe ratio, FRCL is above the weighted average over one and three years. Its discount is modestly wider than the average. FRCL’s ongoing charge is broadly in line with the weighted average and like most of the trusts in the sector, no performance fee is payable. Its gearing is in line with the average. FRCL’s dividend is above the weighted average, ranking seventh out of 15 trusts.

There are eight members 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. Sir Roger Bone was appointed in March 2008; he became senior independent director in April 2016, following the retirement of Christopher Keljik. The other board members and their dates of appointment are: Stephen Burley (January 2008); Jeffrey Hewitt (September 2010); Sarah Arkle and Nicholas Moakes (March 2011); and Francesca Ecsery (August 2013). The newest member of the board is Edward Knapp; he was appointed in July 2016. FRCL’s board is diverse; the directors have a wide range of backgrounds and experience.