Lowland Investment Company — Seeking opportunities in unloved UK stocks

In spite of an increase in volatility from the historically low levels seen in 2017, equity markets have continued to make good progress so far this year, with UK indices breaking through all-time highs. As shown in Exhibit 2 (left-hand chart), small- and mid-cap companies have performed significantly better over the past 10 years than the blue-chip FTSE 100 index, although the FTSE AIM index, which contains many smaller companies, has struggled in comparison with the other indices. Aggregate valuations remain reasonable (right-hand chart), with the FTSE All-Share index on a 2018 forward P/E of 14.2x, although consumer sectors, healthcare and technology are trading on above-average valuations. Given ongoing uncertainty over the outcome of Brexit negotiations and the impact of a potential global trade war, there is scope for continued volatility as the year progresses, which may be exacerbated in the summer months when trading volumes tend to be low. Against such a backdrop, dividends may continue to be an important element of total returns, and investors may prefer to focus on well-run companies trading on undemanding valuations.

Launched in 1963, LWI invests mainly in UK-listed companies, with the aim of achieving above-average returns with growth in both capital and income. While it is a member of the AIC UK Equity Income sector, LWI’s focus is on total return rather than a high starting yield, with the managers seeing income growth primarily as an outcome of capital appreciation. LWI has been managed since 1990 by James Henderson at Janus Henderson Investors, assisted since 2013 by Laura Foll, who was appointed joint fund manager in 2016. Foll is on maternity leave until September 2018.

The portfolio is managed with a focus on value and recovery situations, and the managers maintain a relatively long stock list (c 120 companies) to limit stock-specific risk. They seek to invest in companies whose quality and growth potential are underappreciated by the market, regardless of company size or industry sector. Up to 20% of assets (currently 3.3%) may be invested in companies listed outside the UK. LWI uses the FTSE All-Share index as a benchmark, but tends to have a much higher weighting in mid- and small-cap stocks than the benchmark, which is dominated by the largest 100 stocks (80% of the FTSE All-Share index market capitalisation at 31 May 2018). The trust may also hold UK stocks that are outside the benchmark, for example those listed on the Alternative Investment Market (AIM).

LWI is structurally geared through £30m of loan notes maturing in 2037, and also has a flexible short-term borrowing facility of £60m, equating to available gearing of c 20% of NAV.

James Henderson comments that investors are once again beginning to take notice of UK equities, which he says were the least favoured of all investment areas in a fund manager survey early in 2018. Given fears over the impact of higher price inflation coupled with a lack of wage growth, companies whose earnings are largely domestic have been more out of favour than those UK companies with a high proportion of overseas earnings, and Henderson says this presents interesting opportunities for a contrarian investor, with opportunities to refresh the LWI portfolio. From the market highs seen in January, P/E valuations fell back to levels more in line with historical averages as share prices declined, leading to better value opportunities.

While pressure on the UK consumer has led LWI’s managers to reduce exposure to retailers of big-ticket items such as cars and furniture (see page 5), they have added consumer stocks in other areas, such as brewery and pub operator Greene King, which Henderson describes as having a quality product in its ale Old Speckled Hen, as well as a good pub estate with genuine asset value. Greene King’s premises include the oldest pub in England, Nottingham’s Ye Olde Trip to Jerusalem (established 1189). Henderson notes that companies such as Greene King have seen a modest bear market, reflecting concerns over the property sector, but that this means he has been able to find good companies trading at very attractive valuations. “Given how difficult the retail sector is, it shouldn’t be a surprise if we get some write-downs, but there is also room for positive surprises,” he adds.

Political risk is another reason why some companies have been downgraded, such as in the regulated utility sector, where a general move away from areas seen as bond proxies (driven by the expectation of rising interest rates) has been compounded by concerns over the potential for re-nationalisation under a Labour government. Recent purchases Severn Trent and HICL Infrastructure play into this trend, but Henderson sees the political risk as overdone, given the size of parliamentary majority (particularly in England) that would be necessary to push through such reforms.

LWI’s investment process remains essentially unchanged since its launch in 1963, and has four main pillars:

The managers filter their investment universe of c 1,500 companies using a range of valuation criteria to identify those companies that can generate a growing income alongside capital appreciation. Henderson and Foll prefer companies whose prospects are underappreciated by the market and have the potential to recover and grow. The managers meet hundreds of firms each year and may also pick up investment ideas from colleagues in Janus Henderson’s UK and global equities teams. They look for companies they believe have real potential for sales and earnings growth, and although technically LWI is an income fund, they are happy to invest in companies that are not currently paying a dividend, as long as there is fairly near-term potential for them to do so. The trust has a relatively long list of stocks, which the managers say is an appropriate risk-reduction measure given the focus on recovery situations and the high weighting in small-cap and AIM-listed companies. Positions are built gradually (usually starting at c 30bp) and exited gradually, often to crystallise the benefits of strong performance and guard against reversals of sentiment in stocks where the valuation may not be justified by the fundamentals.

Henderson and Foll seek to build a diversified portfolio spanning the whole range of market capitalisations, from household-name blue-chips to early-stage small-caps. While historically the portfolio has been invested broadly one-third each in large-, mid- and small-caps, Henderson and Foll have found fewer opportunities recently in the FTSE 250, where strong performance has seen valuations become stretched. Conversely, they have found better value among large-caps, with the FTSE 100 weighting now approaching 50% of the portfolio. Portfolio construction is unconstrained by the FTSE All-Share index benchmark, although LWI’s managers will normally have exposure to each industry sector to reduce the risk of relative underperformance in periods of strong returns in a sector in which they are not invested.

At 31 May 2018, there were 123 stocks in the LWI portfolio, a slight reduction from 126 a year earlier. The top 10 stocks made up 27.3% of the total, an increase in concentration from 25.8% at 31 May 2017, mainly because of a 2.1pp increase in the largest position, Royal Dutch Shell. As a bottom-up portfolio, sector weightings can diverge markedly from the FTSE All-Share index benchmark, as shown in Exhibit 3. Financials and industrials are the two largest weightings in absolute terms and are both also significantly above the benchmark weighting. Consumer goods, meanwhile, is a large underweight. The largest changes in exposure over the year to 31 May were a 3.4pp increase in financials, a 2.4pp increase in utilities, a 2.4pp reduction in consumer goods and a 2.2pp fall in consumer services, as the managers feel less optimistic for UK consumer spending on big-ticket items such as furniture and cars. Positions in furniture retailer DFS and car dealership Marshall Motors were fully exited in H118.

The managers have been net buyers of stocks in recent months, using LWI’s low-cost gearing to take positions in companies such as Greene King and Severn Trent, both of which have dividend yields above the cost of the borrowing. The proportion of the portfolio in large-cap FTSE 100 stocks has increased, with new positions in Land Securities (bought H217) as well as Severn Trent (bought H118), and an increase in the Vodafone position in H217 and the Royal Mail holding (bought H117) in H118. In line with LWI’s all-cap approach, however, new positions have also been taken in smaller stocks, including three bought at IPO in H217 – kettle safety switch maker Strix; non-standard motor insurer Sabre Insurance; and Bolton-based investment bank K3 Capital, which specialises in small-ticket corporate deals in the North of England, such as buying smaller pub chains or portfolios of shops. Another small stock added to the portfolio is AIM-listed Finnish pharmaceutical company Faron Pharmaceutical, part of a c 3.5% allocation to early-stage companies. Better-known larger names have also been added, such as HICL Infrastructure Fund and retail property owner Hammerson, which was bought at a c 40% discount to asset value, sold after a takeover bid pushed up the price, and was subsequently repurchased after the failure of the bid saw the discount re-emerge.

Exits or reductions in holdings are most often the result of profit-taking in companies where valuations look stretched (all of the biggest contributors to performance in FY17 were reduced before the year-end, with Scapa being completely exited). Industrial companies Senior and GKN were both reduced on these grounds in H217, with GKN subsequently fully exited after a takeover bid in H118. However, recent sales have been concentrated in the consumer area (DFS and Marshall Motors, as noted above), with convenience store chain McColl’s also reduced in H217.

While LWI’s long-term performance record is impressive (annualised share price and NAV total returns of c 10% over 10 years and c 12.5% over James Henderson’s near 28-year tenure), recent share price and NAV returns – although positive over all periods shown – have been behind the FTSE All-Share index benchmark. Leading contributors to outperformance in FY17, for which the NAV total return was 17.0% compared with 11.9% for the benchmark, included Conviviality, Scapa, Stobart Group, Irish Continental Group and Marshalls. All of these were reduced and Scapa was fully exited on the back of strong performance; however, Conviviality was still held at the time of its collapse in March 2018, and became the biggest detractor in H118. Other detractors in the half-year included Renold, Low & Bonar, 4D Pharma, Carclo and Carillion (which was only c 0.2% of the portfolio when it went into liquidation in January), while the largest positive contributions came from K3 Capital, Royal Mail, GKN (taken over by Melrose Industries in H118), Hiscox and Avon Rubber.

At 25 June 2018, LWI’s shares traded at a 7.7% discount to cum-income NAV. This was narrower than the widest discount in the past 12 months (9.2%) but represents a substantial widening from the 12-month low of 1.5% reached in February. It is also higher than both short- and longer-term averages (6.3%, 4.8%, 2.8% and 4.0% respectively over one, three, five and 10 years). While LWI’s board has the authority to repurchase up to 14.99% of shares annually to manage a discount, in practice this power is not used, with no buybacks having taken place in any of the last 10 years.

LWI has one class of share, with 27.0m shares in issue at 25 June 2018. Gearing of up to £90m is available through a £30m issue of 20-year loan notes and a three-year £60m borrowing facility with Scotiabank. If fully drawn, these would represent gearing of c 20% of net assets; actual net gearing was 14% at 30 April 2018, up from 6.3% at end-FY17.

Following a change to the management fee in 2017, Janus Henderson is paid 0.5% pa of the first £375m of net assets and 0.4% pa thereafter. Previously the fee was a flat 0.5% pa. A further change with effect from 1 October 2018 will see the management fee and finance costs split 50/50 between the capital and revenue accounts. Previously all costs except the performance fee were charged to the revenue account. A performance fee may be paid if the NAV total return is more than 10% ahead of the FTSE All-Share index return. This fee is capped at 0.25% of net chargeable assets, meaning total fees are a maximum of 0.75% up to £375m of assets and 0.65% thereafter. Ongoing charges for FY17 were 0.58% (FY16: 0.63%), or 0.68% including the performance fee.

LWI pays dividends quarterly, with interims in April, July and October, and a final dividend in January. The interim dividends have tended to be at the same level as the prior year’s final dividend, with a 1p increase at the final stage. FY17 saw three interim dividends of 12p and a final dividend of 13p. So far in FY18, two interim dividends of 13p have been declared, and the board has guided that, barring unforeseen circumstances, dividends will total 53p for the year, an increase of 8.2% on FY17. The total dividend has been maintained or increased every year since 1975, growing at 9.9% pa compound over the past five years. Dividends were fully covered by income in eight of the last 10 financial years, and the move to charging half of management fees and finance costs to capital will boost the revenue account; had the policy been in place in FY17, revenue returns would have been 54.5p instead of 49.1p. LWI had revenue reserves of 49.9p per share at end-FY17. After deducting the FY17 final dividend this falls to 36.9p per share, or 75% of the total dividend. Based on the current share price and the last 12 months’ dividends, LWI has a dividend yield of 3.3%.

The AIC UK Equity Income peer group is one of the larger AIC sectors, with 24 constituents. Exhibit 7 shows the 12 largest, all of which have a market cap above £350m. LWI is towards the smaller end of this group. Its NAV total returns are broadly in line with or above average for the group over one, three, five and 10 years. Ongoing charges are below average, although LWI is the only fund in the group to charge a performance fee. The discount to NAV and the level of gearing are both higher than average. LWI’s dividend yield is a little below average, in line with its focus on sustainable dividend growth rather than a high headline yield.

LWI has five independent, non-executive directors. Robert Robertson was appointed to the board in 2011 and became chairman in January 2017. Karl Sternberg and Kevin Carter both joined the board in 2009. Duncan Budge was appointed in 2014, while Gaynor Coley became a director in 2016 and was appointed chairman of the audit committee in 2017. The directors’ professional backgrounds are in industry, investment management and accountancy.