Standard Life Equity Income Trust — Update 30 January 2017

As shown in Exhibit 2 (left-hand side), the FTSE 250 and SmallCap indices have significantly outperformed the FTSE 100 and AIM 100 indices over the last five years (although underperformed in 2016). The valuations of UK indices are shown in Exhibit 2 (right-hand side); while P/E multiples are at or close to the high end of their historical ranges, the valuations of smaller-cap companies look relatively attractive versus larger-cap companies. While they have lower average dividend yields, their income can be more sustainable. Between 2014 and 2016 there has been a succession of FTSE 100 companies cutting dividends, including selected resource stocks and supermarkets. As a result of low earnings growth, dividend cover of the FTSE 100 index is below 1x. This compares to the FTSE 250 index, where dividend cover is closer to 2x; in addition, it has a superior dividend growth track record versus the FTSE 100 index and studies from Goldman Sachs show that companies that grow or initiate dividends outperform in total return terms over the long term. In a continued low interest rate environment, for investors seeking exposure to UK equities, a fund with a focused income bias, broad exposure across the capitalisation spectrum and a good long-term performance track record may be of interest.

SLET was launched in 1991 and originally managed by Morgan Grenfell, which was acquired by Deutsche Bank. Standard Life Investments (SLI) took over management of SLET in November 2005 following Deutsche Bank’s decision to exit the UK retail funds market. Since November 2011, SLET has been managed by Thomas Moore, who aims to provide above-average income and real growth in capital and income. He has an unconstrained investment style with a higher exposure to mid- and small-cap equities than the benchmark FTSE All-Share index. The portfolio normally comprises 50-70 positions – SLET’s top 10 holdings may not exceed 50% of net assets and no single holding will exceed 10%. Portfolio turnover is typically between 20% and 35% pa. The board has delegated gearing responsibility to the manager; a range of 5% net cash to 15% net gearing is permitted although, in practice, net gearing is generally c 10%.

The manager suggests that 2016 was a year of “unexpected changes in the macro drivers”, such as the result of the UK’s referendum, the outcome of the US election and a significant recovery in the oil price, and that macro surprises could continue in 2017. Brexit had a negative effect on SLET’s performance as c 50% of its portfolio companies’ revenues are generated in the UK. Following Donald Trump’s election in the US, there has been a shift from monetary to fiscal stimulus, which has been mirrored in the UK; Moore expects this trend to continue. SLET’s largest sector exposure is financials, which typically benefit from a steepening of the yield curve. The trust tends to own more financial and cyclical stocks and fewer bond proxies than its peers, and so the manager suggests its relative performance should improve in an environment of accelerating growth and higher interest rates.

The manager is open-minded about the potential impacts of Brexit on the UK economy; so far, UK companies have generally been upbeat in their commentary. There is a perception among economists that UK consumption growth will slow, but so far this is not being backed up by economic or corporate data. However, there are some companies (not held by SLET) that are being affected by industry-specific factors, such as Foxtons, which is seeing lower sales volumes as a result of higher stamp duty, and easyJet, which the manager suggests is suffering from too much European short-haul capacity. Moore comments that there is a wide valuation disparity between companies generating profits domestically and those generating profits overseas. He adds that this has only occurred two other times in the last 13 years – during the global financial crisis and around the time of the Scottish referendum. When domestic-earning companies have become this cheap on a relative basis, their stocks have subsequently rallied. More generally, there are signs that sentiment towards the UK is improving on the back of more robust economic data, as evidenced by the FTSE 100 hitting new all-time highs.

The manager and the well-resourced UK Equity team at SLI employ the firm’s Focus on Change philosophy, which recognises that at different times in the economic cycle there are different factors that drive individual stocks and markets. When analysing a company for potential inclusion in the portfolio, the following five questions are considered:

The wide potential investment universe of c 1,500 stocks is screened using SLI’s proprietary stock-screening matrix; factors include earnings growth and revisions, stock price momentum, valuation and dividend yield. Stocks that pass the screen are subject to rigorous fundamental analysis, which includes an evaluation of a company’s dividend policy and its corporate governance track record. The resulting portfolio contains 50-70 high-conviction positions and, while the manager is unconstrained by the stock and sector weightings of the FTSE All-Share benchmark, risk is monitored using SLI’s sophisticated risk modelling system.

At end-December 2016, the top 10 positions accounted for 29.2% of the portfolio; this is modestly higher than end-December 2015. Excluding cash, 44.1% was in FTSE 100, 36.2% in FTSE 250, 8.4% in FTSE SmallCap and 11.3% in non-index companies. By way of comparison, the benchmark FTSE All-Share index is split approximately 80% FTSE 100, 15% FTSE 250 and 5% in FTSE SmallCap. SLET has a much larger percentage in smaller stocks than the benchmark; these stocks generally have higher potential for sustainable dividend growth than mega-cap stocks.

As shown in Exhibit 3, more than one-third of the portfolio is invested in financial companies. Over the last 12 months to end-December 2016, the largest increases in exposure are in basic materials (+5.7pp) and financials (+2.8pp), and the largest decreases are in industrials (-6.7pp) and consumer services (-4.3pp). SLET is heavily overweight the financial sector, which detracted from performance in 2016, and reflecting the manager’s unconstrained investment approach, has zero exposure to the healthcare sector, which comprises c 10% of the benchmark. The manager suggests that the research and development pipelines at pharmaceutical companies such as AstraZeneca and GlaxoSmithKline remain disappointing in spite of heavy investment spend. Within the oil & gas sector, the manager has recently become more positive – the oil price has rallied and both OPEC and non-OPEC producers have agreed to reduce production. He has recently (December 2016) initiated a small position in BP, which has been actively cutting costs since the 2010 Deepwater Horizon oil spill, suggesting a better outlook for dividend growth and cover.

One of the recent additions to the portfolio is Premier Asset Management, which had its initial public offering in October 2016; SLET participated and received a reasonable allocation. It is a retail asset management group across a range of strategies including multi-asset, equity and absolute return funds. It is benefiting from the trend of IFAs spending more of their time on financial planning and less time on selecting funds, which they are outsourcing to multi-managers such as Premier. The company has had 15 consecutive quarters of positive net inflows, is growing earnings at a double-digit rate and trading on a forward P/E multiple of c 13x.

Classified within the consumer goods sector are holdings in housebuilders Bovis, Galliford Try and Persimmon. They are trading on attractive dividend yields and the manager suggests that a lot of bad news is already priced into the stocks, despite the companies issuing positive trading statements. Outside London, housing activity is brisk, so this is an example of good news stories that are being ignored by the wider investment community.

Other cyclical stocks in the portfolio with overseas earnings and strong market positions that have lagged the broader market despite continued solid trading include the following:

The manager comments that he aims to provide above-average returns with real growth in capital and income by investing on an unconstrained and index-agnostic basis. For FY16 ending 30 September, SLET’s NAV and share price total returns of +0.9% and -2.7% respectively trailed the benchmark’s +16.8% total return. FY16 relative performance was affected by limited exposure to large-cap companies with overseas earnings, which significantly outperformed small-and mid-cap companies with domestic operations both before and after the UK’s EU referendum and the underperformance of some of SLET’s large-cap holdings, such as BT, even before the announcement from its Italian subsidiary. In periods of market stress, stock market leadership can be particularly narrow – for example, SLET’s relative performance in FY16 was affected by not holding BP or Royal Dutch Shell, both mega-cap companies that rallied strongly in a rising oil price environment. The largest positive contributors to relative performance in FY16 were holdings in Micro Focus International (1.1pp), Sage (0.7pp) and Barclays (0.7pp). The largest detractors to performance were a holding in Staffline (-1.3pp) and not holding Royal Dutch Shell (-0.9pp), BP and British American Tobacco (both -0.7pp).

A tough period of relative performance over the last 12 months has affected SLET’s positive three-year performance record. However, its NAV and share price total returns remain ahead of the benchmark over both five and 10 years.

SLET’s 7.4% share price discount to cum-income NAV is wider than the 3.5% average of the last 12 months. Over the past year the range has been a from 3.5% premium to an 11.3% discount – the widest discount occurred on 3 November 2016, a period of heightened investor risk aversion ahead of the US presidential election. The current discount is also wider than the averages of the last three, five and 10 years (2.3%, 3.0% and 4.0% respectively).

Issued in December 2010, SLET had a line of subscription shares, the last exercise date for which was 30 December 2016 at 320p; their listing was suspended on 3 January 2017. For shareholders not electing to exercise their rights, the final subscription trustee exercised the outstanding rights to 2.14m shares; those shareholders received 70.6p per share (the difference between the prevailing market price and the exercise price, minus costs). As a result, SLET now has a single line of shares; there are currently 49.2m ordinary shares in issue. The trust has a £30m lending facility with Scotiabank; the average cost of borrowing in FY16 was 1.5%. At end-December 2016, net gearing was 9.7%. Standard Life Investments receives an annual management charge, which is charged 30% to revenue and 70% to capital. The fee is calculated as 0.65% on the first £250m and 0.55% on assets above £250m, (prior to October 2016 it was 0.65% of gross assets). FY16 ongoing charges were 0.96%, a 2bp increase versus the previous year.

Dividends are paid quarterly in March, June, September and December. The FY16 dividend of 15.4p was a 4.8% increase versus the prior year; it was 1.16x covered by revenue. Over the last five years the annual dividend has compounded at an average rate of 4.4% per year, which is above the level of annual UK inflation. Based on the current share price, SLET’s dividend yield is 3.9%, which is higher than the weighted average of the UK Equity Income peer group.

SLET is a member of the AIC’s UK Equity Income sector, which comprises 23 funds. Exhibit 8 shows the largest 15, which have a market capitalisation higher than £175m. SLET’s NAV total returns are behind the whole peer group average over one, three and five years, ranking 22nd, 18th and 12th over one, three and five years respectively, its weaker performance over one year having affected the longer-term track record. At the time of our last report in June 2016, SLET ranked eighth, sixth and ninth out of 23 funds over one, three, and five years respectively. The weaker near-term performance has had an impact on SLET’s risk-adjusted returns, as measured by the Sharpe ratio, which now lag the weighted averages over one and three years. SLET’s ongoing charge is above average, but no performance fee is payable. Its discount is modestly wider than average, its net gearing is broadly in line, but it has a higher than average dividend yield, ranking 10th out of 23 funds in the sector.

There are five directors on the board at SLET; all are non-executive and independent of the manager. Chairman, Richard Burns, was appointed as a director in 2006 and assumed his current role in December 2014. Josephine Dixon was appointed in 2011, Mark White in 2013 and Jeremy Tigue in 2014. The newest member of the board is Caroline Hitch, who has a background in investment management. She was appointed on 1 January 2017 to replace Keith Percy, who retired after 25 years as a director of the trust.