The Law Debenture Corporation — Resilient business model in testing times

The sharp rise in inflation, exacerbated by the war in Ukraine, and the first significant increase in interest rates for many years, with expectations that this will continue, have created a challenging environment for financial markets so far in 2022. Global economic growth has slowed, with the prospect of recession, of unknown depth or duration, anticipated in an increasing number of economies, and equity and bond markets have weakened.

While global equity markets have fallen by c 11% in H122 in sterling terms, the broad UK equity index has performed relatively well by comparison, down 4.6%. We attribute this to the valuation support offered by UK equities compared with other global equity markets as well as the sector composition of the broad UK equity market. It has a relatively a higher weighting to those areas that have been relative beneficiaries of the current environment, such as energy and other natural resources, and a low weighting towards technology stocks.

Against this background, during the six months to 30 June 2022 (H122), LWDB’s NAV total return (with debt at fair value) was -4.0% compared with the broad UK market return of -4.6% and the Morningstar UK equity income peer group return of -6.4%.1 Long-term performance is strong and on the same basis is ahead of the broad UK market return on a three-, five- and 10-year time horizon. It is also well ahead of long-term inflation, measured by the change in the Retail Price Index.

During H122 there was a wide disparity of returns within the UK market, both by sector and by market capitalisation. The portfolio managers, James Henderson and Laura Foll from Janus Henderson Investors, note that the robust performance of the FTSE All-Share Index2 during the period was concentrated at the top end of the FTSE 100 Index, reflecting the strong performance of large natural resources and other defensive sectors such as pharmaceuticals. The wider market was much weaker, with the median share in the FTSE 350 Index stock down by 19.7%. This worked against the managers’ investment approach (discussed later in this report), which includes within the highly diversified portfolio a significant weighting to small and mid-cap stocks. The negative impact on portfolio performance was partly mitigated by its holdings in natural resources, but this did not offset significant price declines in some other sectors, such as retail.

Dividends have increased for 12 consecutive years and have been held or increased for 43 years. Over the 10 years to end FY21 the dividend more than doubled, increasing by 114.8%. Including the rebasing to a higher level of distribution in FY19,3 the five-year compound rate of DPS growth is 11.7%, compared with a peer group average of 3.3%.4 The 2019 rebasing distorts the comparison but demonstrates LWDB’s commitment to progressive income distribution. The first interim DPS for FY22 increased 5.5% to 7.25p compared with Q121 and the second interim dividend will be announced in September; the company is targeting aggregate FY22 DPS of at least 29.0p (FY21: 29.0p). In support of this, we note that portfolio income increased by over 55% to £18.4m, from £11.8m in H121, at the upper end of the managers’ expectations and that the revenue reserve is strong at £44.9m (versus 35p per share).

Long-term performance benefits from relatively low charges,5 supporting a strong track record of dividend distributions. However, a key driver of long-term dividend growth and overall returns remains LWDB’s IPS business. Over the past 10 years IPS has funded 36.4% of dividends, well ahead of its c 19% contribution to fair value NAV. As we discuss below, despite facing similar headwinds to the investment portfolio, it increased H122 revenues by 11.3% compared with H121 and PBT by 5.9%, in line with the company’s mid-high single-digit target.

Both Henderson and Foll continue to highlight the investment flexibility provided by the steady, cash-generative nature of LWDB’s IPS business as a key contributor to long-term performance. It enables them to invest in lower- or non-yielding stocks while still meeting LWDB’s investment objective of providing a steadily increasing income. The flexibility also extends to the ability to avoid being forced by income requirements into high-yielding stocks that the managers may deem unattractive.

Over the short term, the managers expect inflation to remain elevated and interest rates to rise further, but for both to later ease as the significant impact on annual inflation from this year’s rise in energy and other commodity prices falls away. The governor of the Bank of England has signalled the potential for taking stronger action to bring down inflation, interpreted by many as a 0.5% increase in base rate, to 1.75% in August. Financial markets appear to be pricing in an increase to c 3.0% by around the end of the year, before easing. The managers note that the general fall in UK equity prices leaves the UK market valuation at a low level and that it would require a decline of at least 20% in average company earnings to bring this back to average historical levels. They argue that corporate balance sheets are conservatively positioned to weather the economic downturn and that operating performance may come to be seen as surprisingly robust. While they expect earnings downgrades to come through, they anticipate that much of this may have been priced in. Reflecting this outlook, the managers continue to identify attractive investment opportunities and continue to be selective buyers of a diversified list of well-run companies that have strong leadership and low valuations.

In the following section of this report we provide an update on developments with IPS before examining the portfolio strategy in greater depth and updating on the trust valuation.

LWDB’s IPS business, comprising the pensions, corporate trust and corporate services divisions, demonstrated its resilience in H122, with each business line increasing revenues year-on-year despite an increasingly challenging and uncertain economic and political backdrop. Over longer periods, this same resilience reflects a diversified range of operations, significantly based on recurring income from structurally supported sectors, and others that provide attractive returns but with increased market sensitivity.

Once seen as a steady but reliable and cash-generative business, operational performance was reinvigorated following the appointment of Denis Jackson as CEO in 2017 and it is now into its fifth consecutive year of growth in revenues and earnings. H122 revenue increased by 11.3% compared with H121 and PBT by 5.9%, in line with the company’s mid-high single-digit target. Although lower than in recent periods, PBT margin remains strong at 29.0% (H121: 30.5% and an average 35% in the five years to end-FY21). The primary impact on margin in the period was staff costs, c one-third of total costs. This reflected a continued increase in headcount, part of IPS’ investment in its skills base, technology and capacity for growth, and pressure on remuneration resulting from intense competition for skilled staff across many parts of the financial and professional services industries. The success of IPS is largely built on the quality of service that it delivers, and it cannot be immune from these competitive pressures.

With new business momentum continuing, the company expects that revenue growth will follow investment. It also has some scope to pass through inflationary cost increases to revenues, including from revenue streams that benefit from contractual inflation uplifts. Additionally, with a strong and liquid balance sheet (group cash and equivalents of c £72m at end-H122) we expect IPS to remain alert to attractive external growth opportunities that may emerge.

LWDB’s pensions business was established more than 50 years ago, initially as a pensions trustee where it remains the largest, as well as the longest established, independent pension trustee in the UK. In 2021 it launched a similar offering in the Republic of Ireland. The pension trustee business is complemented by its fast-growing Pegasus operation, launched in late 2017, providing a broad range of services, from secretarial through to fully outsourced pension scheme management.

Revenues in the pensions business increased by 7.9% in H122, and growth in the past four years has averaged 12.1% pa. This continues to be underpinned by demand for high-quality expertise to navigate an increasing regulatory burden. Over shorter periods, events such as the coronavirus pandemic and, more recently, increased volatility in financial markets can place additional stresses on pension schemes and their sponsors, increasing the requirements for governance work. The strong upwards move in bond yields in recent months and weakness in other assets will have had a significant impact on scheme assets and liabilities.

Although the largest independent trustee in the UK, it continues to win new clients. With a market share of less than 5% there is plenty of room for this to continue and LWDB continues to invest in the business in anticipation of this. Since it was launched in late-2017, Pegasus has grown strongly. Its c £3m of revenues in FY21 represented almost a quarter of the pensions total. It grew strongly again in H122, and management expects this to continue.

The corporate trust business is the UK’s leading independent (non-bank) corporate bond trustee, with many decades of experience and deep market connections, operating internationally to provide trustee services to a broad range of debt issuance markets. It acts as a bridge between the issuer and the investor, earning recurring revenues from debt issuance until maturity. It also undertakes post-issuance work, including for performing debt issues and non-performing. The business also provides escrow services with a broad range of applications that are typically applied where two parties wish to move or transfer an asset based on certain conditions being met.

Corporate trust revenues increased by 5.0% in H122 despite very challenging conditions for new debt issuance, typically volatile and subject to rapid change. Amid a sharp increase in inflation and interest rates, and war in Ukraine, Dealogic estimates that European debt capital issuance was 27% lower in H122 compared with H121 and European high yield issuance was even weaker (down 69%). Although new debt issuance has been weak, revenues are significantly recurring (c two-thirds of the total), providing a good level of visibility. For regular duties such as acting as a point of contact between the issuer and investor, and for receiving certain financial, security and covenant information from the issuer, LWDB is usually paid recurring fees that benefit from annual inflation-linked increases until maturity. Ad-hoc post-issuance work generates additional fees. For performing debt issues this includes activities such as documentation changes. In more challenging economic circumstances, LWDB is well placed to benefit from countercyclical work, such as debt restructuring or the renegotiation of payment terms, which often continue well after recovery is underway. Unlike previous economic downturns, the pandemic had little impact, with corporate bankruptcy maintained at a modest level by the unprecedented level of financial support offered to corporates around the world. Given the constraints on government balance sheets, pressure on the real disposal incomes of consumers and rising debt costs, it is tempting to think that the normal credit cycle may be at an early stage of re-establishing itself.

As an established business, with a strong reputation and solid, liquid balance sheet, LWDB is well-placed to offer escrow services. These are increasingly used to support corporate merger and acquisition (M&A) transactions, corporate disposals, litigation, global trading and property transactions, but the range of applications is wide. In 2020, during the pandemic, LWDB supported NHS trusts in the purchase of personal protective equipment from around the world, and in H122 the escrow product was used to support the Tyson Fury versus Dillon White world title boxing event.

The corporate services business consists of a broad range of activities that further enhance the diversification of IPS. The key activities are:

Revenues in the corporate services business increased by 17.9% in H122, including an additional one-month contribution from the late-January 2021 acquisition of the corporate secretarial services business of Eversheds Sutherland LLP for £20m. Taking each activity in turn:

The January 2021 acquisition transformed LWDB’s small existing company secretarial offering. It was successfully integrated during 2021, with 99% of its client base retained and new clients won, and LWDB says the combined business is already producing high-quality, repeatable revenues. Meanwhile, it has been investing significantly in headcount, skills, technology and infrastructure to ensure that it can provide the quality of service, and has the capacity, to further grow the business. Supporting the growth prospects is the need for corporates to keep abreast of constantly changing government rules and frameworks and the trend towards outsourcing. As corporates examine their cost bases and seek to optimise capital allocation, large in-house company secretarial departments are increasingly outsourced.

LWDB acts as an agent for service of process for thousands of clients from all over the world with the lowest recurring contractual revenue base of all the IPS businesses. As a result, it is the most sensitive of all the IPS businesses to global macroeconomic trends. 2021 saw a recovery from 2020, as the pandemic lockdowns eased, and economic growth began to recover. Despite increased levels of global economic and political uncertainty, it nonetheless increased revenues by 5.2% in H122. LWDB says that although revenues are volatile the over-the-cycle returns are excellent and it has continued to invest, exploiting the new technology platform introduced last year to streamline and scale up capacity, and to capitalise on its extensive referral partner network.

The UK securitisation market is one of the largest and most developed securitisation markets in Europe and an important source of finance for UK businesses. Structured finance services continued to gain new business in H122, supporting newly structured SPVs. Revenues increased 21% and have increased by an average 11.6% pa over the past four years.

Safecall continued its growth in H121 despite the difficult economic conditions in Europe, adding new clients and handling increased volume of cases.

IPS is a high-margin, cash-generative business that has historically proven relatively insensitive to short-term economic and market fluctuations. In addition to generating substantial distributable income, thereby providing the portfolio managers with greater investment flexibility, the growth in the operational fair value of IPS6 in recent years has also contributed to LWDB’s NAV growth. IPS operational value has more than doubled since end-FY17 through a combination of earnings growth7 and an increasing valuation multiple. The multiple is based on external professional advice from PwC, and we believe that it remains prudent. Although H122 earnings continued to increase, this was offset by a reduction in the valuation multiple from 10.8x to 10.5x, driven by market trends and peer multiples. Nonetheless, the 141.3p per share fair value of IPS at 30 June 2022 compared with an IFRS book value per share of 35.2p. Management initiatives aimed at generating further growth in IPS, along with the scope for further increase in the EBITDA multiple are positive indicators for continuing growth in fair value.

As there is no direct comparator to the make-up of the IPS business, PwC and LWDB have worked together to identify a range of companies that to varying degrees share similar business units, customer bases and market dynamics. From a valuation analysis, based on market data and adjusted differences between the companies in respect of size, liquidity and margin growth, PwC provides a range of valuations that it believes to be appropriate. The board then selects the multiple to be applied, seeking a valuation of the IPS business that is both fair and sustainable.

The comparator companies used in this analysis are shown in Exhibit 5. Within the broader list we show separately the four companies that LWDB considers to be its core comparators, of which three are under offer or engaged in ongoing M&A discussions. For this reason, the chosen multiple has relied more on the broad comparator group and at 10.5x the chosen multiple for IPS is at a 19.8% discount to mean multiple of this group.

Long-term, bottom-up, and value driven

The portfolio managers are focused on long-term returns, with investment decisions driven by a selective, bottom-up approach to stock selection, deliberately diversified by sector and geography. The stock selection process is valuation-driven, aiming to identify high-quality companies that are undervalued at the point of purchase. This includes ‘out of favour’ equities that may be standing at valuation discounts to their long-term historical averages, giving rise to a mildly contrarian style of management. Similarly, stocks where valuations have increased materially, or where the investment case has fundamentally changed, are considered for sale with the proceeds recycled into more attractively valued opportunities.

The wide disparity in returns during H122, across sectors and by market capitalisation, has been the key driver of returns and of portfolio activity. Mirroring market trends, the best performing stocks in the portfolio were either exposed to rising commodity prices (natural resources companies such as Shell, i3 Energy and BP), the prospects for increased defence spending, significantly driven by war in Ukraine (BAE Systems), or rising interest rates (HSBC).

The managers have been adding to domestic banks, Barclays and NatWest, where performance has been less strong. The managers do not expect the positive impact of rising interest rates to be offset by increased bad debt provisioning in a slowing economy, noting increased capital strength and conservative lending since the last downturn.

The main detractors to portfolio performance were a combination of technology (Herald Investment Trust), consumer (Marks & Spencer) and early-stage growth companies (Accsys Technologies).

More generally, exposure to early-stage companies has been a drag. These are businesses that the managers believe have the potential to become substantially larger over time. However, they are not without risk and when market sentiment is poor, they suffer from a retreat to safety. While painful in the short term, these names have historically added value to LWDB investor returns and provided diversification away from the value/income positions that make up the majority of the portfolio.

Consumer discretionary companies have seen valuations fall across the market, but the managers identify opportunities to selectively add to existing holdings. They say that portfolio exposure is largely in companies that have undergone significant ‘self-help’ in recent years and that this has not been reflected in current valuations. They note that Marks & Spencer’s efforts to address legacy store issues and its success in regaining market share have not been recognised in valuation and have added to the holding. The managers also observe that while consumer confidence and disposable income is broadly under pressure, there are consumers that were able to build material savings during the pandemic. They believe this is likely to insulate spending in certain areas such as repair, maintenance and home improvement, and have added to positions in Halfords, Vertu Motors, Marshalls and Ibstock.

Other investments in the period included the addition of positions in Cranswick, the pre-eminent UK pork supplier, to retailers, ITV and newspaper and magazine publisher, Reach. The managers expect the strength and durability of Cranswick’s brands and relationships with the major supermarkets put the company in a strong position to pass through input cost inflation. For ITV and Reach, they feel that the market has become too pessimistic about the outlook for terrestrial TV and online print advertising.

With the valuations of many ‘defensive’ companies at high levels, the managers have taken advantage of the opportunity to recycle capital with sales including RELX, Urban Logistics and Severn Trent.

Further focus on the UK where valuations are favourable

The LWDB investment portfolio continues to be very much focused on UK listed investments and has recently been adding to this. In H122, an additional c £30m was invested into UK equities, mainly funded by stock sales in Europe and the United States. Net portfolio divestment was c £12m, with the UK purchases not fully offsetting the disposals during the period. The most significant sale was of the US oil services group Schlumberger on valuation grounds after a strong share price performance. European-listed basic materials companies Linde (industrial gases and engineering) and Glencore (mining) were also sold. Partly offsetting this, a position was taken in Bayer (pharmaceuticals and life sciences) where the managers are positive about agro-chemical fundamentals as well as the potential for its late-stage pharmaceutical pipeline. More generally, overseas holdings are in companies where there is no compelling UK equivalent. As the UK equity market has been hugely out of favour with global investors for a number of years, with valuations remaining low in an international context, this is where the managers continue to identify the most attractive opportunities.

Janus Henderson Investors estimates that UK equities are trading at the widest discount to global equities in 25 years. They note that the discount is not simply at the level of market indices but is also apparent across most sectors. Although the relative performance of the UK equity market has begun to improve, this is yet to be reflected in positive fund flows. Should flows pick up it would represent a further positive driver for UK equity performance.

High diversification balances risks

At end-June 2022, there were more than 140 stocks in LWDB’s investment portfolio. Concentration in the top 10 holdings remains relatively low but increased to 23.2% compared with 18.6% for the top ten at end-FY21, primarily driven by strong valuation gains in core holdings such as GlaxoSmithKline, Shell, HSBC and BP. In Exhibit 12, the 31 December 2021 weightings refer to the H122 top 10 holdings and in aggregate do not represent the 31 December top 10 holdings.

Changes in sector weights during the period are not particularly material and predominantly relate to performance, net investment flows and the stock selection activity referred to above, rather than being a ‘target’ in themselves.

At 28 July 2022 LWDB’s shares traded at a premium of c 2.6% to cum-income NAV (with both debt and the IPS8 business at fair value), maintaining the re-rating that occurred during the pandemic and well above the previous long-term discount range of c 5–15%. In common with most of the investment trust sector, LWDB saw significant volatility in its rating during the early part of the coronavirus pandemic but, as trading conditions normalised, lockdowns were lifted and the economy bounced back through 2021, the rating steadily improved. It is likely that this in part reflected investors’ appreciation of the more secure income stream from the IPS business amid deep and widespread UK dividend cuts affecting most equity income funds. Some of the re-rating has recently eroded, although the shares have continued to trade above the historical discount range.

During H122, LWDB was able to satisfy investor demand by issuing shares under its authority at an accretive average premium to NAV. Approximately 3.8m shares were issued at an average price of 799p, representing gross proceeds of c £30m.

LWDB has delivered excellent performance for investors, especially within the context of the AIC Equity Income peer group (Exhibit 15). This has been helped in part by the low management fees that investors pay here resulting in a share price that has remained closer to its NAV than many of its peers. When comparing with its AIC UK equity income peers (which is a diverse cohort of 21 funds), it is noticeable too that the average market capitalisation of holdings in the fund, at around £7bn, is much lower that the AIC category average of £13bn. Henderson and Foll are well known for managing multi-cap portfolios and the utilisation of at times less liquid smaller but faster growing companies plays to the advantage of the closed ended structure.

While the managers will look overseas to provide diversification and exposure to sectors not easily found in the UK, the non-UK allocation of 15.4% at the end of June 2022 is not dissimilar to its peers, on average. The AIC sector classification stipulates that over 80% of the portfolio should be invested in UK quoted shares, however the use of non-UK domiciled names in UK equity income portfolios has become more of a feature in portfolios over the past 10 years or more.

Lastly, fund managers Henderson and Foll have a combined average tenure on this fund of almost 15 years (Henderson: June 2003 and Foll: September 2011) which exceeds the already quite material peer group average tenure of 10 years.