UIL — Strong investee company fundamentals to win out

Global stock prices recovered strongly following the COVID-19 related sell-off in March 2020; however, a challenging macroeconomic backdrop means that, so far, 2022 has proved to be a tough period for global investors (Exhibit 1, left-hand side). They are having to come to terms with an extended period of high inflation, which has been exacerbated by the war in Ukraine and lockdowns in China due to its zero-COVID-19 policy, and interest rates are being hiked as central banks move away from their ultra-loose monetary policies in an effort to combat rising prices. Stock market volatility has been elevated as investors react to daily news headlines, and previously highly valued technology stocks have been under particular pressure from rising interest rates, which reduce the present value of their long-term future cash flows.

Forward P/E multiples are looking much more attractive compared with a few months ago (Exhibit 1, right-hand side) as, in aggregate, they are now trading at a discount rather than a premium to their 10-year averages. However, this improvement may prove to be illusory if consensus earnings expectations are overly optimistic. It is not hard to imagine the prospect of negative earnings estimate revisions as corporate margins come under pressure from rising input costs. With such an uncertain backdrop, investors are likely to be better served by employing a cautious approach, seeking high-quality companies with attractive fundamentals whose leadership teams can manage through the current difficult operating environment.

There are a series of challenges for global economies, two of which are causing Jillings the greatest concern as he believes they are significant headwinds to growth. The first is China and its zero-COVID-19 policy, which is leading to shutdowns and disruption of the global supply chain and distribution channels. This will negatively affect global economies as manufacturing inputs are held up. The manager says that the outcome for a resolution is unclear as China’s President Xi Jinping has invested a significant amount of political capital into the country’s COVID-19 policy, so it is difficult to see how he would climb down. Jillings suggests that, ultimately, there are two possible outcomes: either China learns to live with COVID-19, and its economy grows, or lockdowns continue, the Chinese economy slows and this negatively affects other regions around the world.

The other major concern that the manager has is the war in Ukraine, which he considers to a be a brutal and ugly development. Jillings explains that the negative impacts on soft commodity markets will be significant, and product shortages will put real pressure on some societies. He believes that most of the western world should be relatively immune; however, the manager worries that poorer nations will experience food shortages.

Global inflation is rising partly because of the war in Ukraine; however, Jillings opines that a moderation in the pace of higher prices could occur faster than consensus expectations. His view is that inflation is being driven by supply shortages rather than excess demand and, given time, these distortions will be resolved. The manager compares 2021, which saw a spike in demand as COVID-19 lockdowns were lifted, with the 2022 supply disruptions; he believes that if the Russian invasion of Ukraine had not occurred, the global demand/supply balance would have resolved itself, and inflation would not have risen to current levels.

Jillings suggests that the world can deal with inflation and higher interest rates but acknowledges there is a risk that central banks overshoot, by raising interest rates too much and negatively affecting economic growth. In the meantime, people are being challenged by the rising cost of living. The manager believes that corporate earnings will come under pressure as margins will be squeezed due to companies being unable to always pass on higher input costs. Also, with many investors never having experienced inflationary periods, he expects high levels of risk aversion and volatility among all asset classes. However, Jillings highlights full employment as being a positive aspect of the current macroeconomic backdrop. He believes that a jobs shortage means there is a lower risk of recession and although this is likely to result in higher wage inflation the manager considers this to be ‘a better problem to have’.

As shown in Exhibit 2, at end-April 2022, UIL’s top 10 holdings made up 96.9% of the fund, which was the same concentration as a year earlier; nine positions were common to both periods. However, four of the top 10 holdings (Somers, Zeta Resources, Utilico Emerging Markets and Allectus Capital) are platforms with a portfolio of underlying holdings, so UIL’s fund concentration is not as high as these numbers would suggest. The total number of positions including the platforms is c 40 and c 16% of the fund is held in unlisted investments (excluding loans to listed companies and listed companies classed as level 3 investments, which are valued using inputs that are not based on observable market data). UIL’s largest position at c 38% of the fund is Somers, which has a portfolio of more than 10 investments. Its largest holding is Australia-listed Resimac, which is a leading non-bank lending and multi-channel distribution business in Australia and New Zealand. On a look-through basis, Resimac makes up c 20% of UIL’s portfolio, while the top 10 holdings make up 62.6%.

UIL’s geographic breakdown is shown in Exhibit 3. At end-April 2022, the largest increase over the prior 12 months was a higher weighting to North America (+5.1pp); this was partly due to the strong share price performance of Copper Mountain Mining (held in the Zeta Resources platform). The largest decrease was the Middle East/Africa exposure (-4.7pp), which was primarily due to the performance of Resolute Mining.

Jillings reports that UIL’s portfolio is long Australian and Canadian dollars, but due to currency hedges, its sterling exposure is neutral.

There have been modest changes in UIL’s sector exposure over the 12 months to end-April 2022 (Exhibit 4), with a higher technology weighting (+2.7pp) and a lower exposure to the gold mining sector (-1.7pp).

Jillings considers that UIL’s larger investments are performing well in a tough operating environment. He highlights Resimac: this mortgage securitisation business recently released a very strong earnings report; its earnings per share was an all-time high and the manager expects the company to continue to grow its top and bottom line. However, Resimac’s stock price did not react positively as smaller-cap financial service businesses are currently out of favour with investors.

Zeta Resources’ largest holding is Canada-based Copper Mountain Mining, which has had some short-term negative impacts from poor weather (which happens periodically) and lower-grade ore due to increasing its capacity (which was expected). Jillings considers that Copper Mountain is a well-positioned mining business with a strong management team that has been paying down the company’s debt. The firm should benefit from high demand for copper helped by an anticipated acceleration to energy security and green energy. Also, as and when China deals with COVID-19, the manager expects the Chinese authorities to ease constraints on its housing sector and boost infrastructure spend, which should drive increased demand for commodities.

Resolute Mining’s share price has been disappointing as investors have been concerned about the company’s high level of debt and its ability to pay this down while reinvesting in its asset base. However, the manager believes that Resolute is ‘doing a good job’ and expects the company to generate higher levels of cash flow, although the political environment in Mali, where the miner’s largest asset is located, remains uncertain.

In our last review published in November 2021, we highlighted UIL’s modest investment in the Novareum Blockchain Asset Fund. The manager says that blockchain assets have had a ‘torrid time’ experiencing higher levels of volatility than other investments. However, he says that this is unsurprising as any new asset class can be difficult to price.

In H122 (ending 31 December 2021), UIL’s NAV and share price total returns of -9.9% and -5.3%, respectively, lagged the benchmark’s +6.5% total return. However, it is important to remember the company’s very strong relative performance in FY21, where its NAV and share price total returns of +50.9% and +57.0%, respectively, compared with the benchmark’s +21.5% total return.

The primary reason for UIL’s negative total return in H122 was the 23.2% fall in Resimac’s share price, which contributed 8.2% of the 9.9% decline in UIL’s NAV. On the positive side, Zeta Resources’ shares appreciated by 16.2% in H122, driven by the +89.3% move in its second-largest holding, Panoramic Resources, due to a strengthening outlook for nickel prices. Resolute Mining continued to disappoint; its shares declined by 23.8% due to weak operating performance and concerns about the political outlook in Mali.

UIL’s relative performance is shown in Exhibit 7. The company is ahead of the broad UK market over the last five and 10 years in NAV and share price terms and its share price has outperformed over the last three years. While UIL has lagged the performance of the UK market over the shorter periods shown, Jillings comments that while global stock markets have been volatile, he has a high degree of confidence in the portfolio companies’ fundamentals and expects their share prices to perform relatively well in a more stable macroeconomic environment.

UIL is a member of the AIC Flexible Investment sector, an eclectic mix of 24 funds that have a wide variety of investment mandates. In Exhibit 9, we show the largest 17 companies with market caps greater than £50m that have been trading for more than three years. UIL’s NAV total returns are below average over the periods shown. The company has one of the widest discounts in the selected peer group, the third highest ongoing charge and the highest level of gearing by a wide margin. UIL offers an above-average dividend yield that is currently 1.4pp above the mean of the selected peer group.

UIL pays regular quarterly dividends in December, March, June and September. The board aims to at least maintain the total annual distribution, using revenue reserves as required (it also has the flexibility to pay dividends out of capital). In H122, UIL’s revenue earnings per share of 3.40p were 26.6% lower than 4.63p in H121, which was partly due to lower receipts from loans to platform companies Somers and Zeta Resources as they were significantly reduced during the period. So far in FY22, two interim dividends of 2.0p per share (c 0.9x covered) have been paid, which are flat year-on-year. At the end of H122, UIL’s revenue reserves were equivalent to 14.34p per share, which is c 1.8x the last annual distribution. Barring unforeseen circumstances, the board expects to continue to pay quarterly dividends of 2.0p per share for the balance of FY22. Jillings anticipates that UIL’s income will rise in H222 ensuring that the annual dividend is fully covered. Based on its current share price, UIL offers a 3.7% dividend yield.

UIL’s shares are currently trading at a 29.7% discount to cum-income NAV, which is narrower than the 33.2% to 37.9% range of average discounts over the last one, three, five and 10 years (based on monthly NAVs). Jillings is frustrated about the company’s continued wide discount; however, he acknowledges that it is unlikely to narrow in the near term given the current widespread lack of investor confidence. The manager is hopeful that, over time, the discount can narrow to 20%, helped by share buybacks and continued marketing to existing and potential investors. In H122, c 0.3m shares (c 0.4% of the share base) were repurchased at an average discount of 28.8%.

UIL began trading on 20 June 2007 as the successor vehicle to Utilico Investment Trust, which was launched in August 2003 (for more information about the company’s history, please see our December 2019 initiation report). It is a Bermuda-registered company listed on both the Specialist Fund Segment of the London Stock Exchange (which does not have any free float requirements) and the Bermuda Stock Exchange. UIL is managed by ICM Investment Management and ICM (collectively referred to as ICM), which has c £3bn of assets directly under management and is responsible for a further c £24bn of assets in subsidiary investments. ICM has more than 70 staff based in offices in Bermuda, Cape Town, Dublin, London, Seoul, Singapore, Sydney, Vancouver and Wellington. Manager Charles Jillings and the rest of the ICM investment team aim to identify and invest in compelling long-term investments across the globe, where their forecast underlying values are not reflected in their current share prices. UIL may invest in shares, bonds, convertibles and other types of securities, including non-investment-grade bonds. Unlisted securities of up to 25% of gross assets at the time of investment are also permitted. Derivative instruments have been used for investment purposes and efficient portfolio management, and at times currency exposure may be hedged. UIL’s sector and geographic exposure is unrestricted, but at the time of investment, a single investment may not exceed 30% of gross assets (except for platforms, which may not exceed 50%). The company employs a levered strategy through ZDP shares and a limited amount of bank debt (see Gearing section on page 9). UIL’s ZDP shares are listed on the Standard Segment of the Main Market of the London Stock Exchange. At end-April 2022, net gearing (ZDP shares plus borrowings) was 64.5%, which is below the board’s targeted maximum of 100%. UIL’s performance is benchmarked against a broad UK equity market index. Data from the company show that from inception to the end of April 2022, its NAV total return compounded at a rate of 12.1% pa.

ICM’s investment teams are led by Duncan Saville and Charles Jillings. The other senior members of the team are: Jacqueline Broers, Jonathan Groocock and Mark Lebbell, focused respectively on the telecommunications, utilities and infrastructure sectors; fixed income specialist Gavin Blessing; Dugald Morrison, who covers resources; Jason Cheong and Matt Gould, who focus on technology and emerging technologies; and Alasdair Younie, covering financial services. UIL seeks to generate long-term capital growth by investing in undervalued assets across the globe. Businesses may be under-priced for a variety of reasons including technological change, competition, an inefficient balance sheet, an underperforming management team or a lack of investor interest. Around 80% of UIL’s portfolio is invested in four ICM-managed funds, referred to as ‘platforms’: Somers (financial services), Zeta Resources (natural resources), Utilico Emerging Markets Trust (emerging markets utilities and infrastructure) and Allectus Capital (technology, with a particular focus on fintech). Jillings suggests this approach offers the following benefits:

The remaining c 20% of the fund is in direct holdings including Australian gold miner Resolute Mining. The manager stresses the importance of supporting investee companies with their capital requirements and says UIL may often be among their largest shareholders, maintaining regular contact with them. There is no limit as to how much of a company UIL can own, and it may sometimes take legal or management control of a firm.

ICM is committed to a strong environmental, social and governance (ESG) framework and is taking steps to strengthen its policy and public profile. The company is a signatory of the United Nations-supported Principles for Responsible Investment (PRI). The PRI is an international organisation that works to promote the incorporation of ESG factors into investment decision-making. UIL’s board believes it is in shareholders’ best interests to consider ESG factors when selecting and retaining investments. In conjunction with assessing the financial, macroeconomic and political drivers when making and monitoring an investment, the manager embeds ESG opportunities and risks into the firm’s investment process. Companies are scanned using a rigorous in-depth framework. However, the decision on whether to make an investment is not made on ESG grounds alone. Factors are incorporated into the process in three main ways:

The board believes that an analysis of ESG factors helps to enhance the understanding of a company, as these factors affect their business models and their long-term ability to generate sustainable returns. It also enables UIL’s investment team to fully question a company’s investment potential from a variety of perspectives.

UIL follows a levered strategy using ZDP shares and bank debt. It has a £50m senior secured multicurrency revolving facility with Scotiabank Europe, which expires at the end of September 2022. The board stated its commitment to reduce the company’s debt and gearing in the FY14 annual report and it has fallen from more than 150% at 30 June 2013 to 60.7% at 31 December 2021. At the end of April 2022, net gearing was 64.5%, which is well below the board’s 100% maximum target.

UIL has an exemplary track record of redeeming its 2012, 2014, 2016, 2018 and 2020 ZDP shares; the next redemption date is October 2022. The company’s capital structure provides holders with attractive yields and a range of maturity dates, which enables it to realise a smaller number of investments in advance of each redemption date, so is therefore less disruptive to the portfolio. Exhibit 13 shows UIL’s current four tranches of ZDP shares spread over seven years; they are issued by UIL Finance, a wholly owned subsidiary of UIL. Over time, the company’s capital growth is driving higher ZDP cover, and its financing costs have declined meaningfully in recent years from an average rate of 6.3% at the end of June 2013 to 4.5% at the end of December 2021.

ICM receives an annual management fee of 0.5% pa of UIL’s total assets less current liabilities (excluding borrowings and excluding the value of all holdings in companies managed or advised by ICM or its subsidiaries from which it receives a management fee), along with 45% of ICM’s costs of providing company secretarial services. ICM is entitled to a 15% performance fee on NAV returns over benchmark at the higher of 5.0% or the UK gilt five- to 10-year index post-tax yield plus RPIX inflation. The NAV must exceed the high-water mark NAV from when the performance fee was last paid (adjusted for capital events and dividends paid) and the fee is capped at 2.5% of financial year-end NAV (adjusted for capital events and dividends paid). It is also reduced to take into account any performance fees paid to ICM by companies where UIL is an investor. In H122, UIL’s ongoing charges (excluding performance fees) were 2.0%, which were in line with H121. Including performance fees, ongoing charges were 4.2% (H121: 2.9%). UIL’s ongoing charges appear high compared with other investment companies as the expense calculation is based on a percentage of average net assets (after the deduction of the ZDP shares).

UIL has 83.8m ordinary shares outstanding, the majority are of which are held by companies associated with ICM manager Duncan Saville or UIL’s directors; hence, the free float is c 20%. Over the last 12 months, the company had an average daily trading volume of c 17k shares.

Collectively, UIL’s board has experience in a wide range of financial services and the law. David Shillson is considered to be a non-independent director as he is a senior partner of a law firm that has acted for associates of UIL and ICM from time to time. In FY22, the remuneration is £47,600 for the chairman; £45,500 for the chairman of the audit and risk committee; and £35,200 for the other three directors.