Jupiter UK Growth Investment Trust — Rigorous, long-term approach to stock-picking

Equity markets globally performed strongly since the beginning of 2016, and peaked in January 2018. As shown in Exhibit 2, although UK equities also appreciated meaningfully during this period, the FTSE All-Share index significantly lagged the FTSE World ex-UK index. A slight pullback in UK equities, combined with positive earnings momentum has helped moderate valuations. The UK index’s PE multiples are around 12% above its 10-year average, but on a price-to-book measure, valuations are only 85% of the 10-year average. Meanwhile, returns on equity have improved materially to 132% of the 10-year average, having become very depressed during the global financial crisis.

The significant divergence in performance between global and UK equities is reflected in very low asset allocations to UK equities. According to the proprietary BAML Global Fund Manager Survey (which surveys active investment managers globally), allocations to UK equities fell sharply following the announcement of the EU referendum and have continued to fall, currently at a post-global financial crisis low. This suggests global fund managers have very limited expectations for Brexit outcomes and the UK domestic economy. Such an environment could present interesting opportunities for investors with a contrarian, long-term approach.

JUKG was launched in 1972 as the Jupiter Primadona Growth Trust (JPG) and was renamed the Jupiter Growth Trust in November 2015. In April 2016, the trust’s mandate changed from a UK and global growth to a UK growth strategy, and the trust was renamed to Jupiter UK Growth Investment Trust, and Steve Davies was appointed its new manager. JUKG largely mirrors the strategy of the £1.4bn Jupiter UK Growth Unit Trust, which has been managed by Davies since 2015 (he was deputy manager between 2009 and 2015).

The trust’s objective is to generate capital growth, primarily from investing in UK-listed equities. Its approach is bottom-up, seeking to build a concentrated portfolio of around 35 high-conviction stocks. There are relatively few investment constraints and the portfolio can diverge significantly from the FTSE All-Share index benchmark. In December 2017, James Moir joined as an analyst dedicated to the UK growth strategy. Moir brings considerable equities analysis experience and knowledge of the financials sector, having previously worked at UK Financial Investments, helping to oversee the UK government's holdings in Royal Bank of Scotland, Lloyds and UK Asset Resolution.

Davies believes the stock-market environment is changing. Over the past few years, UK equity performance has been driven by several big macroeconomic and political themes. Interest rates and stock market volatility (as measured by the US VIX index), have been unprecedentedly low for an extended period, and have started to rise. A weak sterling has been a benefit to large-cap multinationals and a reversal could present headwinds; and the manager expects China’s growth to slow, removing some of the upward pressures on commodity prices. This environment is “less forgiving” for UK equities, while politics may continue to be erratic. However, this is an environment well-suited to stock-picking, which is the essence of Davies’ investment approach.

As well as rigorous bottom-up analysis with a long-term view, active engagement with companies’ boards is also important. In addition to meeting the senior management teams of companies, Davies undertakes a continuous programme of engagement with chairmen and other board members to enhance his understanding of a company as well as add value through constructive two-way conversations. Davies cites GKN as an example of successful engagement helping an improved investment outcome. JUKG has held GKN for almost a decade, but more recently, its performance had been disappointing. Since early 2017, Davies has engaged with board members and the chairman, sharing his views on a number of issues including weak areas of management and a need to radically improve the group structure to drive profitability and cash flow. The manager believed the GKN stock price materially undervalued the company. A continued dialogue with the chairman, allowed for a better-informed view of the firm, supporting the decision to retain the GKN position despite a profit warning, and a difficult transition to a new CEO. This conviction has been rewarded as the takeover proposal by Melrose represents a significant uplift in GKN’s valuation.

Davies believes his approach to management engagement differentiates JUKG from many funds, and notes many chairmen have commented that it is rare to meet a fund manager, rather than a corporate governance specialist. The manager undertakes the engagements himself and addresses issues relevant for each particular company, aiming to meet the chairmen of all portfolio companies at least once a year, as well as other board members. This approach is a core part of the investment process and is possible because of the relatively small number of holdings on the portfolio, most of which are located in the UK.

The investment objective of the fund is to generate long-term capital growth. There are few constraints on sector, size and geography, allowing the manager to focus on a stock’s individual merit. An analyst by background, Davies undertakes detailed fundamental analysis of companies, and has a long investment horizon.

The manager looks for two broad categories of investments, recovery and growth (currently around 46% and 53% of the portfolio, respectively). Recovery stocks are those that have been ‘written-off’ or deemed ‘uninvestible’ by the market, but have catalysts (such as new management or industry restructuring) that could trigger a rerating. These companies typically trade at very attractive valuations, on P/E ratios below 10x (or below book value for banks) and free cash flow yields above 10%, with substantial upside potential. Growth stocks are companies that can deliver consistently strong growth over the medium term. Their earnings prospects are predictable, not speculative, and the companies are cash-generative, typically with free cash flow yields above 5%. The manager currently identifies five investment themes, which are reflected in the portfolio: UK domestics; financials; brands, leisure and travel; the connected world; and tomorrow’s world. The first two categories are relatively out-of-favour sectors, reflecting the manager’s contrarian bias. Tomorrow’s world is effectively ‘patient capital’. Fibre-optic network provider, City Fibre is one of these companies, held for nearly three years. It has recently agreed a takeover bid at a 93% premium to the pre-bid price.

As JUKG’s investment mandate is relatively unconstrained, seeking a concentrated number of high-conviction stocks, the portfolio typically diverges considerably from the index. As shown in Exhibit 3, the largest sector exposures in JUKG are to consumer services (39.0%) and financials (31.9%). Consumer services encompasses a broad range of companies, with the largest positions being British Airways owner, International Consolidated Airlines; Dixons Carphone; and Thomas Cook. The manager believes the squeeze on UK real wages over the past several years is coming to an end, which will support domestic consumption. However, he does not favour consumer goods, where multinationals and food manufacturers feature prominently. Davies regards these as bond proxies that have also benefited from a weak sterling, and could be adversely affected by rising interest rates.

UK banks are ‘self-help’ stories, as multi-year restructuring efforts start to bear fruit, while the worst of the pain from rising capital requirements and settlement for misconduct has passed. Lloyds is the largest bank stock in the portfolio (7.4%, Exhibit 1). It has returned to profit and a recent announcement of an increased dividend and share buyback suggests management’s confidence in its prospects. Barclays is also a top 10 holding and the manager believes its target for double-digit returns on tangible equity is achievable (and US tax changes are helpful). At which point, the stock could rerate meaningfully to trade at a premium to book value. Cyclically, financials are also natural beneficiaries of rising interest rates, which help improve net interest margins and boost profitability.

Although JUKG primarily invests in UK equities, it is permitted to own up to 10% in overseas equities. Following the purchases of three new positions, the international component of the portfolio was 9.7% as at end-March 2018. US-listed Yum China owns and operates KFC and Pizza Hut restaurants in China, and is a play on rising consumer spending and volume growth. The company currently has around 8,000 restaurants and plans to double this number by rolling out 500–600 additional outlets pa. The business is highly cash-generative and generates a free cash flow yield above 5%. Italy-listed Ferrari is also a volume growth story, targeting a doubling of profits by 2022 and a significantly improved cash flow. It currently sells around 8,000 cars pa, but has the capacity to produce 14–15,000, and its strong brand is well-placed to benefit from a growing number of high net worth individuals globally. Ferrari plans to broaden the range of its models; for example, introducing a four-seater, which could potentially appeal to the Chinese market where buyers of luxury cars prefer to be driven and sit in the back. The manager’s extensive research into Ferrari brought F1 (Formula 1) on to its radar screen. He views F1 as a highly profitable, yet poorly managed sport and, through the knowledge and insight gained from owning Manchester United, sees huge opportunities under new management (Liberty Media) to leverage off sponsorship and social media.

JUKG has not held oil & gas nor utility stocks for some time, as the portfolio consists of a concentrated number of stocks in which the manager has high conviction. The manager has been a longstanding bear on the price of oil, based on structural supply-side disruption as shale production rises, and weak discipline within OPEC to adhere to agreed quotas. A rapid adoption of electric cars and change in consumer habits to own fewer cars could also present demand-side disruption.

As the current JUKG mandate was adopted in April 2016, the most useful performance periods to consider are one, three and six months, and one year. The trust’s total return NAV has lagged the benchmark over one year. Over the shorter periods of one, three and six months, performance has broadly mirrored its benchmark.

The board introduced a nil-discount policy in February 2014, and as shown in Exhibit 7, this has been effective at maintaining the share price close to the trust’s cum-income NAV. The company aims to control the supply and demand for shares through new share issuance and share repurchases (subject to annual shareholder approval). During the first six months of FY18, 0.8m shares were repurchased at a cost of £2.7m.

JUKG is a conventional investment trust with one class of share in issue. The reconstruction of Jupiter Dividend & Growth Trust on 30 November 2017 permitted its shareholders to roll over into JUKG, resulting in the issue of 7.8m new shares at 315p per share, increasing assets by £24.6m. There are currently 19.5m shares in issue.

The management fee consists of a base fee and a performance fee. The annual base fee is 0.50% of net assets up to £150m, reducing to 0.45% between £150m to £250m of net assets, and 0.40% above £250m. A performance fee is subject to a 2% hurdle over the FTSE All-Share index total return, above which JUKG is entitled to 15% of the outperformance, with a high watermark of the NAV at the end of the prior year. The combined total fee is capped at 2% of year-end adjusted net assets. As at end-December 2017, the ongoing charges ratio (excluding finance costs) was 1.26%. The trust has as £17m loan facility with Scotia Bank, which was fully drawn down as at end-April 2018 and net gearing was 12.0%.

In April 2016, the board changed the dividend policy from paying quarterly dividends to one annual payment. The FY17 dividend of 7.0p per share maintained the aggregrate level of dividends paid in FY16 and represents a yield of 2.0%.

Exhibit 8 shows the 16 members of the AIC UK All Companies sector, with the addition of Jupiter UK Growth unit trust as a comparator. As the current JUKG mandate came into place in April 2016, the most relevant NAV total return performance period is one year, where it ranks 10th. It is one of the smallest trusts by market capitalisation, which contributes towards a relatively high ongoing charge compared with the group. As one of just two trusts in this sector that operates a zero-discount policy, JUKG has one of narrowest discounts to ex-par NAV among peers, while its dividend yield is around average.

Following the appointment of Keith Bray as a director of JUKG on 28 March 2018, the board has five independent non-executive directors. Bray was a former director of Jupiter Dividend and Growth Investment Trust. Chairman Tom Bartlam was appointed in July 2013 and assumed his current role in November of that year. The other board members and their years of appointment are Lorna Tilbian (2001), Jonathan Davis (2011) and Graham Fuller (2013).