Foreign & Colonial Investment Trust — Still going strong after 150 years

Exhibit 2 (left-hand side) shows the potential benefits of global investing as over the last 10 years, global equities (in sterling terms) have considerably outperformed the returns of the UK stock market. In 2018, global equity markets have returned to more normal levels of volatility following a particularly benign period in 2017, with investor concerns centring on macroeconomic issues such as the implications of disruptions to global trade, and the UK’s ongoing negotiations to exit the EU. However, against this backdrop, corporate earnings growth remains supportive for further global equity gains, albeit with more modest upside than in recent years. Although equity valuations in general have expanded, there are still pockets of value, such as in Japan, which on a forward P/E basis is trading at a discount to its 10-year average (Exhibit 2, right-hand side). In such an environment, investors may be attracted to a global fund with a wide remit that includes exposure to regions where valuations are relatively more attractive.

Launched in 1868, FRCL is the oldest investment trust. It initially invested in bonds, but made its first equity investment in 1925 (by 1965, equities made up 95% of the portfolio). The trust has also invested in private equity since 1942. FRCL has had 11 managers in the last 150 years; current manager Paul Niven is only the third since 1969. He aims to generate long-term growth in capital and income, and attractive risk-adjusted returns from a diversified global portfolio of listed equities and unlisted securities (including private equity).

FRCL is benchmarked against the FTSE All-World index. Risk is managed via diversified investment across geographies and sectors (there are no specific geographic or industry sector exposure limits for the publicly listed equities). A maximum 5% of the portfolio at the time of investment may be invested in unlisted securities (excluding private equity) and requires prior approval by the board. Shareholder approval would be required to increase FRCL’s private equity exposure above 20%. At the time of investment, a maximum 10% of the portfolio is permitted in a single investment and up to 5% may be in funds managed by BMO Global Asset Management (subject to board approval). Gearing in either sterling or foreign currencies is permitted up to a maximum 20% of NAV (net gearing was 8% at the end of July 2018).

FRCL has over 100,000 investors, 90% of whom are retail rather than institutional holders, and the manager notes that the average age of new investors is coming down, suggesting the trust’s appeal is broadening. Data from Newlands Fund Research suggests a £100 investment in FRCL at the time of the fund’s launch in 1868 would now be worth c £13m. The board intends to increase the annual dividend once more in 2018, which would represent the 48th annual increase (the trust has paid a distribution every year since launch).

At the beginning of 2018, Niven believed the bull market was not over and there was potential for further share price appreciation on the back of global economic growth. He expected increased equity market volatility, compared to the very benign levels in 2017, higher dispersion of equity returns and wider credit spreads. He also believed stocks that had been leading the global stock markets would continue to do so. So far this year, all of these expectations have come to fruition. One prediction that was less successful was the expected outperformance of financial stocks due to higher interest rates and credit growth in Europe. So far in 2018, financials have lagged; however, the manager suggests these stocks will perform better in the second half of this year as a result of a continued improvement in their fundamentals. Although Niven remains optimistic on the outlook for global equities, supported by corporate earnings growth, he notes there are macroeconomic issues to consider, such as trade conflicts as a result of the US’s protectionist policies. Further out, he says there could be monetary policy missteps as a result of an underestimation of inflationary pressures, although he suggests this is not a near-term issue to concern investors.

Niven aims to generate long-term growth in capital and income from a portfolio of global securities that is widely diversified by geography and sector. He is benchmark aware but does not follow the FTSE All-World allocations. FRCL’s portfolio is constructed with inputs from both BMO’s specialist teams and third-party managers (see Exhibit 3) and includes a c 7% allocation to private equity. Individual strategy allocations are regularly reviewed and altered when deemed appropriate by the manager. He believes a key feature of the trust is its broad diversification in both listed and unlisted securities, which helps both to reduce risk and to limit the volatility of investment returns.

FRCL aims to generate an attractive, good long-term total return while reducing risk. Its diversified range of strategies is highlighted in Exhibit 3; Niven believes this approach will allow the trust to continue to deliver good risk-adjusted outcomes. The manager is continuing to adjust FRCL’s private equity strategy. In H118, there were 10 early-stage investments, five of which were primary and five were co-investments, and there were £65m in new direct commitments during the period. There will continue to be significant cost savings as the trust’s historic private equity fund-of-fund investments in HarbourVest and Pantheon are run off.

FRCL’s geographic exposure is shown in Exhibit 4. Over the 12 months to end-July 2018, the largest changes in the trust’s exposure are to North America (+4.1pp), although the trust remains underweight versus the benchmark, and to Europe ex-UK (-1.5pp) and the UK (-1.4pp). Niven explains that UK exposure has become a much smaller part of FRCL’s portfolio, which is unlikely to change. Since the end of H118, there is no longer a direct allocation to UK equities and starting with the 2018 annual report, the UK will be included with Europe, classified as pan-European exposure.

FRCL has recently released its H118 report (to 30 June). Its NAV and share price total returns of 3.7% and 8.0% respectively were ahead of the benchmark’s 2.1% total return. The breakdown of the trust’s H118 returns is highlighted in the waterfall chart below (Exhibit 6); the higher share price total return compared to the NAV total return accompanied a reduction in the trust’s discount.

There was good performance from FRCL’s underlying strategies, with most outperforming their respective benchmarks. During the period, an underweight exposure to North America detracted from returns, but was more than offset by positive stock selection and the trust’s private equity exposure. Within the key US equity strategies, both the growth and value managers outperformed their respective benchmarks. T Rowe Price generated a 14.9% total return, outperforming its growth benchmark by 5.0pp, while Barrow Hanley generated a 2.9% total return, outperforming its value benchmark by 2.1pp. Despite the much higher returns from growth rather than value shares in the US, the manager explains that he is happy with the two managers’ allocations, and US equity exposures will not be rebalanced. FRCL’s private equity strategy generated a 9.6% total return during H118, which compares favourably with the 2.1% total return from global listed equities.

FRCL’s relative returns are shown in Exhibit 8. Its share price has outperformed the FTSE All-World index over one, three, five and 10 years, whereas its NAV has outperformed over one and five years and is broadly in line over three and 10 years. The potential benefits of investing in overseas rather than domestic equities are illustrated by FRCL’s outperformance versus the FTSE All-Share index over all periods shown.

Since mid-2016, FRCL has enjoyed a meaningful narrowing in its discount. H118 ended with the lowest discount since 1996, which the board said it found very satisfying as it has been focused on narrowing the discount for a long time. Historically, the board targeted a maximum discount of 10%, but this was reduced to 7.5%, and this target has now been removed altogether; however, the board will repurchase shares if the discount widens meaningfully in normal market conditions (no share repurchases were made during H118). It will consider issuing shares if FRCL consistently trades at a premium.

FRCL’s current 1.4% share price premium to cum-income NAV compares to the range over the last 12 months of a 1.4% premium to a 6.1% discount. It is narrower than the average discounts of the last one, three, five and 10 years (a range of 3.0% to 8.8%).

FRCL is a conventional investment trust with one class of share in issue. There are currently 542.2m ordinary shares in issue, with a further 19.6m held in treasury. The trust is permitted to gear up to 20% of NAV; at the end of July 2018 net gearing was 8%, which compares with a range of 7% to 14% since 2012. As a result of a series of debt refinancings at attractive interest rates, FRCL’s weighted average cost of debt has declined to 2.8% at the end of H118, which is meaningfully lower than 7.1% at the end of 2013, prior to the maturity of a longstanding 11.25% debenture. The £345m gross debt at end H118 was split as follows: a £20m 1.12% revolving credit facility (expiring in 2018); ¥6.6bn at 2.50% and $80m at 4.00% (maturing in 2019); €72m at 1.69% (2022); £25m at 2.80% (2028); £50m at 3.16% (2031); £75m at 2.92% (2048); and a £0.6m 4.25% perpetual debenture.

BMO Global Asset Management is paid an annual management fee of 0.365% of FRCL’s market cap and the trust also pays direct fees to its external managers. The board believes FRCL’s ongoing charges of 0.79% (in line with FY16) are competitive with its peers given that part of the asset management function is outsourced.

FRCL has a very distinguished dividend history. An annual distribution has been paid in every year since the trust was launched in 1868. In addition, the board intends to pay a higher dividend in FY18 than in FY17 (at a growth rate in excess of UK inflation), which would represent the 48th year of consecutive dividend increases.

The 10.40p per share total dividend paid in FY17 was 5.6% higher than 9.85p paid in FY16 and was more than 1.1x covered. In H118, net revenue was 7.78p per share, which was 7.5% higher year-on-year (+5.0% excluding special dividends). Based on its current share price, FRCL’s dividend yield is 1.4%.

FRCL is a member of the AIC Global sector. In Exhibit 10, we highlight the 14 trusts in that sector with less than a 25% exposure to the UK. FRCL is the second-largest fund in the selected peer group, with a market cap approaching £4bn. Its NAV total returns are broadly in line with the averages over the periods shown. Since mid-2016, FRCL’s discount has been in a narrowing trend and its shares now regularly trade close to NAV. The trust’s ongoing charge is in line with the selected peer group average (despite paying fees to external managers) and, in common with most of its peers, no performance fee is payable. FRCL’s net gearing is above average, while its dividend yield is modestly lower than average; although investors should remember the trust’s distinguished track record of dividend growth.

There are eight directors on FRCL’s board, all of whom are non-executive and independent of the manager. The chairman is Simon Fraser, who was elected to the board in September 2009 and assumed his role in May 2010. Sir Roger Bone has been the senior independent director since November 2011 and joined the board in March 2008. The other six directors are: Jeffrey Hewitt, appointed in September 2010; Sarah Arkle and Nicholas Moakes, both in March 2011; Francesca Ecsery in August 2013; Edward Knapp in July 2016; and Beatrice Hollond in September 2017.