The Scottish Investment Trust PLC — Greater conviction for global contrarian

In spite of the growing consensus towards the end of extraordinary monetary policy in the US, UK and Europe, world stock markets have continued to perform strongly (Exhibit 2, left-hand chart), with a divergence between the UK and the rest of the world since the EU referendum in June 2016 helped by the boost to overseas asset values from the weakness of sterling. Forward P/E valuations in all major regions are now above 10-year averages (right-hand table), although they are less extended in Japan and Asia. Dividend yields remain attractive relative to cash and bonds, although any significant increase in bond yields could dampen investor enthusiasm for risk assets. With the risks arguably to the downside, investors may prefer an approach that focuses on finding under-appreciated value rather than following indices that may be vulnerable to a correction.

The Scottish Investment Trust (SCIN) is one of the longest-established investment trusts, launched in 1887 and celebrating its 130th anniversary this year. It remains based in Edinburgh and is self-managed. In the last three years the trust has streamlined its operations, outsourcing the majority of its administrative functions and reducing its investment team to four members, who have revamped the investment process to take a high-conviction, contrarian approach to global equity investment. The trust aims to achieve capital appreciation and above-inflation dividend growth.

Because of the unconstrained and contrarian nature of the management style, the trust does not have a formal benchmark. However, in order to provide context to performance, SCIN uses the MSCI AC World and MSCI UK All-Cap indices (previously the FTSE All-World and FTSE All-Share) in communications with shareholders. Gearing is permitted up to 20% and the trust has an active discount management policy.

Fund Manager Alasdair McKinnon explains SCIN’s contrarian approach as taking advantage of the opportunities that arise from the ‘crowd mentality’ of many investors: “When things are going well in the markets, you get commentary telling people they must be involved, and vice-versa when things are going badly. People often end up buying at the top and selling at the bottom. We think our job is to avoid that mistake – to take a lateral thinking approach and analyse stocks on a more realistic way of thinking.” A key part of this is to take as little notice as possible of index weightings; “if you start comparing to anything, it can influence how you think and behave,” says McKinnon. He points out that the increased prevalence of passive investment strategies can provide great opportunities for contrarian or value-biased active managers, with passive money flowing in and out of baskets of stocks based on factors such as how the Brexit negotiations are deemed to be proceeding, and comparatively little effort being made to unearth hidden gems. Furthermore, the focus on out-of-favour stocks with good dividends or strong cash flows means there should be an element of downside protection in any wider market setback, as the most heavily backed stocks are likely to be hit harder when sentiment turns negative.

SCIN follows a high-conviction, ‘global contrarian’ investment approach. Fund Manager Alasdair McKinnon, who is supported by Deputy Manager Martin Robertson and investment managers Sarah Monaco and Mark Dobbie, explains that the approach is informed by behavioural finance techniques, and specifically tries to spot investment opportunities that arise as a result of the human desire to be part of a crowd. This instinct has its roots in prehistory, where people’s safety and survival may have depended on sticking together and following rules and norms. However, McKinnon points out that it can often be observed in equity markets, where ‘herding’ behaviour causes investors to continue to back popular stocks long past the point where future returns are limited, and to shun those that have done poorly, even when the seeds of improvement may already have been sown. The core of the SCIN process is, essentially, to do the opposite, which can lead to superior returns through buying unloved stocks with recovery potential at low valuations. The process is necessarily index-agnostic, given that index weightings reflect past performance rather than future prospects. Stocks are initially assessed based on their position in sentiment and capital cycles; where the entry point is judged to be favourable, the team undertakes valuation work to analyse the drivers of the business, the yield and sustainability of the dividend, P/E ratio and cyclical earnings position.

McKinnon splits the portfolio into three categories of company:

At 30 June 2017, SCIN had 54 holdings. This is a significant drop compared with 69 a year previously, and reflects a fall in the typical number of stocks from 70-120 to 50-100, underscoring the higher-conviction approach. This has resulted in a temporary increase in the normally low level of turnover. The team used the Aviva transaction (for which it was necessary to raise funds in order to repurchase shares) as a means of increasing portfolio concentration, selling out of holdings where the level of conviction was lower, rather than reducing holdings across the portfolio. As shown in Exhibit 3, the largest sector weightings are in financials (where many ‘ugly duckling’ banks have performed well), energy and consumer sectors. Both sector and geographical weightings reflect bottom-up stock selection rather than top-down allocation. The low weighting in the US compared with most global indices reflects the generally high level of valuations across the market, while the UK has proved a better source of out-of-favour stocks. Geographical weightings are broadly stable compared with 12 months previously.

SCIN has produced strong absolute returns, with 12-month share price and NAV total returns of 30.5% and 24.1%, respectively, and annualised total returns of c 12-15% over three and five years (Exhibit 4). The share price has also outperformed world equity indices over the past 12 months, although the manager is keen to stress that the portfolio is run without reference to benchmarks, as this tends to skew investors towards targeting relative rather than absolute performance. Contributors to recent performance include ‘ugly ducklings’ from within the banking sector, which saw a rerating following the election of President Trump, and a variety of holdings in the ‘change is afoot’ category, including largest holding Treasury Wine Estates, Rentokil Initial and Citizens Financial. Within the ‘more to come’ group, Microsoft and Comcast (the latter no longer in the portfolio) did well in H117.

At 21 July 2017, SCIN’s shares traded at a 9.0% discount to cum-income NAV and a 7.6% discount to ex-income NAV (both with debt at fair or market value). This is narrower than both short- and longer-term averages. Under the trust’s discount control policy, shares may be bought back if the discount exceeds 9%; the presence of this cushion has maintained the discount within a narrow band, and average figures range from 10.6% over one year to 9.9% over 10 years. Excluding the Aviva transaction (see below), c 6m shares have been bought back in the past 12 months.

In common with most investment trusts, SCIN’s discount widened immediately after the UK’s EU referendum in June 2016, and again just before the US election in November (Exhibits 6 and 7). Since then, the discount has returned to its longer-term range.

A conventional investment trust, SCIN has a single share class, with 82.3m ordinary shares in issue at 21 July 2017. A discount control policy sanctions the use of share buybacks (up to 14.99% pa) to maintain the discount at or below 9% in normal market conditions. During FY17, the calculation basis for the purposes of this target has been changed from the ex-income to the cum-income NAV with borrowings at fair or market value. The number of shares in issue reduced by 18% over the 12 months to 30 June 2017, partly as a result of the discount management programme, but mainly because of a special transaction to facilitate the exit from the share register of Aviva, which owned a 12% stake in SCIN as a result of its acquisition of Friends Life. SCIN uses gearing via a 30-year issue of secured bonds, arranged in 2000 with a coupon of 5.75%, as well as £2m of perpetual debenture stock. Some of the original £150m bond issue has been paid back, and £83.7m of debt (based on par values) was outstanding at end-H117, representing gross gearing of c 11%. Net gearing was 5.8% at 30 June 2017 versus a maximum permitted level of 20%.

As a self-managed investment trust, SCIN does not pay a management fee, and there is also no performance fee. For FY16, total expenses (including staff costs, administration, legal and professional fees) were £4.1m, equating to an ongoing charges figure of 0.49%.

SCIN currently pays dividends twice a year, in July and February. However, in view of investor appetite for a more regular income, quarterly dividends will be paid from FY18. Part of SCIN’s investment objective is to achieve dividend growth ahead of UK inflation. The trust has grown its annual dividend each year since 1983, a record bettered by only 13 other investment companies, and long-term dividend growth is also well ahead of UK inflation. The board aims to grow the regular dividend in a steady manner; as such, in years when portfolio income is high, a special dividend may be paid (as it has been in three out of the last four financial years). A large revenue reserve – in excess of four years of the FY16 regular dividend at end-H117 – gives the board the flexibility to continue to grow the regular dividend if portfolio income is lower. So far in FY17, an interim dividend of 5.5p has been declared, a 4.8% increase on the H116 interim. For FY16, an annual dividend of 13.5p (5.25p interim plus 8.25p final) was augmented by a 9.0p special dividend. Based on dividends for the last 12 months and the current share price, SCIN has a dividend yield of 1.7% excluding or 2.8% including the special dividend.

SCIN sits in the AIC’s Global sector, which contains many of the largest and longest-established investment trusts. Below in Exhibit 8, we show a subset of the 23-strong peer group that SCIN’s board and managers currently consider to be most comparable. However, it is important to underline that SCIN does not measure its performance with reference to any index or peer group. In NAV total return terms, SCIN ranks towards the lower end of the peer group over one, three, five and 10 years, although the impact of overhauling the investment approach may be becoming evident in the shorter-term figures, which are closer to the peer group unweighted average (weighted averages are skewed by the strong performance of the giant £5.6bn Scottish Mortgage trust). The peers differ widely in focus, and SCIN has the third-highest UK weighting and the lowest US weighting in the group, which will have had an impact on relative returns against a backdrop of weak sterling and strong US market performance. Ongoing charges are competitive (among the lowest in the investment trust universe, not just within this peer group), and SCIN does not charge a performance fee. Gearing is broadly in line with the average, while the discount is towards the wider end. SCIN’s dividend yield (based on FY16 dividends, including special dividend) is the highest in the group; excluding the special dividend, the yield of 1.7% is still above average.

There are six non-executive directors on the board of SCIN. Chairman James Will has been a director since 2013 and has been in his current role since January 2016. Hamish Buchan joined the board in 2003 and will retire at the 2018 AGM. Russell Napier was appointed in 2009 and Ian Hunter, chairman of the audit committee, became a director in 2014. The newest directors, Jane Lewis (chairman of the remuneration committee) and Mick Brewis, joined the board in December 2015. The directors have backgrounds in stockbroking, investment management, accountancy and law, and most have professional experience in the investment company sector.