JPMorgan Global Growth & Income — Strong outperformance from focused global fund

Investors in global equity markets have seen positive returns over the last 12 months, boosted for those based in the UK by the weakness of sterling since the EU referendum in June 2016. As shown in the 10-year performance chart in Exhibit 2 (left-hand side), the catastrophic losses of the global financial crisis now seem little more than a bump in the road. However, after such a long period of relatively stable gains (punctuated by bouts of volatility in 2015 and early 2016), average equity market valuations (right-hand table) are now looking extended.

Many market participants are relatively sanguine about the high level of forward P/E valuations, pointing out that, having been depressed for some time, earnings are recovering, which brings a measure of justification to higher prices. What is perhaps more important for investors is to recognise that averages mask a wide variance of valuations by sector and company, with some areas looking extremely extended while others may offer better value. While the global economy looks in relatively good shape – the IMF forecasts world GDP growth of 3.5% in 2017 and 3.6% in 2018 – there are still geopolitical risks that could dent enthusiasm for equity markets. In such an environment, income-seeking investors may favour a strategy that centres on finding growth at attractive valuations.

JPMorgan Global Growth & Income (JPGI) was launched in 1887 but has followed its current investment approach (under the name JPMorgan Overseas until July 2016) since 2008. Managed by Jeroen Huysinga at J.P. Morgan Asset Management (JPMAM), it is the only UK retail investment fund to offer access to JPMAM’s high-conviction global focus investment strategy. The strategy was developed in 2003 as an extension of JPMAM’s research-driven global equity investment process, and draws on the expertise of the firm’s large analyst team. JPGI invests globally in a relatively concentrated portfolio of 50-90 stocks, chosen for their value and growth potential. The trust measures its performance against the MSCI All Country World Index.

While the investment process principally focuses on capital growth, the trust has historically paid a small dividend. In order to broaden its appeal to yield-seeking investors, in July 2016, JPGI announced a new distribution policy whereby a minimum of 4.0% of year-end NAV would be paid out via quarterly dividends. The investment approach (which has historically produced a dividend yield of c 1-2%) is unchanged, and distributions may be partly funded out of capital returns or revenue reserves. In addition to bringing the trust within the scope of investors who require a yield at least commensurate with that of the domestic market (currently 3.5% for the FTSE All-Share Index), the board felt that the certainty of income afforded by declaring the dividend at the start of the year would be a further attraction.

Gearing is permitted in a range of 5% net cash to 20% geared, and currency exposure is hedged to match the benchmark.

Manager Jeroen Huysinga points to a major change in investor attitudes over the past year that has favoured JPGI’s valuation-focused investment process. In early 2016, a period of risk-aversion, market participants were concentrating on stocks offering perceived long-term safety, defensive cash flows and stable yields – propelling these companies to very high valuations relative to history – while eschewing cyclical stocks or anything with perceived near-term volatility. This led to unprecedented valuation disparities in some sectors, he says, which gave him the opportunity to add to holdings in cyclical areas where share prices were falling.

In the second half of 2016, a lot of the macro headwinds faded: there was no emerging market collapse or contagion and markets took unexpected events such as the UK’s Brexit vote and the election of Donald Trump as US president in their stride. Huysinga says the stabilisation in markets, coupled with the recovery in depressed cyclical areas such as banks, was much more constructive for the process, and has led to a significant upturn in performance (see page 7). However, the relative performance of the cheapest versus the most expensive quintile of stocks on a rolling 12-month basis is still below its long-term average, so the manager argues there is still considerable scope for strong performance to continue.

From a macro perspective, Huysinga welcomes the return of a degree of inflation to the global economy. For most of the period from 2012 to 2016, less than a quarter of countries globally had rising inflation; the figure is now more than half, which means a headwind to the investment process should start to abate, as companies such as Finnish stainless steel producer Outokumpu – a top five holding – begin to recover a degree of pricing power, leading to earnings upgrades.

The JPGI investment strategy is based on J.P. Morgan Asset Management’s dividend discount model (DDM), described in detail in our initiation note. This is a process followed by JPMAM’s large global equities analyst team, and implemented by Jeroen Huysinga as manager of JPGI. Broadly, the DDM is a cash flow-based valuation approach that seeks to assess long-term expected stock returns by generating earnings and cash flow estimates over a range of time horizons. Inputs to the estimates include the quality of a company’s management and products, its competitive position and use of cash. Analysts synthesise a projected dividend stream for each company and equate this to the current share price in order to calculate a dividend discount rate (DDR), a measure of internal rate of return. The higher the DDR, the better the long-term value of the company. The team splits the universe of c 2,500 companies into 17 sectors, grouped under broad headings of financials, healthcare, consumer, TMT (tech, media, telecom) and industrials. Within each sector, stocks are ranked into quintiles based on their DDR; for JPGI, Huysinga focuses on the two cheapest quintiles, although all quintiles are monitored by the analyst team.

Having a valuation in the two cheapest quintiles is the first of four tests a stock must pass to be considered for inclusion in the JPGI portfolio. The second test is significant profit potential, measured as having at least 25% upside from current to normalised earnings per share. Applying these two criteria narrows the investment universe from c 2,500 to c 500 stocks. Thirdly, there must be an identifiable catalyst for the market to re-evaluate its view of a company, such as expansion into new markets, restructuring or a new management team. The final test is the time horizon over which the catalyst should occur, broadly within six to 18 months. This is not a target holding period, however; because the DDM is used to assess companies on their long-term earnings potential over as much as eight years, stocks may still offer significant growth potential well after the market has begun to appreciate their qualities.

Applying these four tests results in a list of c 50-90 stocks, which form the basis of the JPGI portfolio. The analyst team constantly reassesses the universe, which allows the manager to ensure that every stock in the portfolio continues to meet all four criteria. New positions are sized at c 0.5-1.5pp above their MSCI AC World Index weight, with the level of conviction based not just on valuation but also perceived risk, liquidity, the number of catalysts and the timeline for their achievement. The portfolio is diversified geographically and by sector, subject to certain broad constraints:

At 31 March 2017, JPGI had 88 holdings, towards the top of its 50-90 stock range. The strict valuation focus of the JPGI investment process means that turnover in the portfolio can be relatively high, at 60-80% a year, as stocks may move out of the two cheapest valuation quintiles, prompting a reassessment of the investment case and often a switch into something offering better value.

Over the nine months from end-FY16 to 31 March 2017, the trust saw its exposure to Europe and the UK increase, while Japan and emerging markets exposure fell and the US weighting remained broadly stable. Compared with the MSCI AC World Index (Exhibit 3), JPGI is overweight Europe and the UK, underweight North America, emerging markets and developed Asia, and broadly neutral on Japan. While the fall in the pound since mid-2016 may have caused more UK stocks to fall into the two cheapest valuation quintiles, Huysinga points out that the relatively large UK position is not a sterling bet, as it is mostly made up of international companies such as Intercontinental Hotels and building supplies firm Wolseley, which do the majority of their business outside the UK, although there is some domestic exposure through housebuilders such as Taylor Wimpey. The UK is also home to some favoured stocks that are disrupting markets through the use of technology, such as online fashion retailer ASOS (active in the UK, US and Europe) and used car marketplace Autotrader, which is focused on the domestic market but is largely insulated from any economic downturn because of its focus on second-hand vehicles.

From a sector perspective, one of the biggest moves since end-FY16 has been the reduction in semiconductor exposure, previously the trust’s largest overweight position. Huysinga says the analyst team’s sector co-ordinator, Rob Bowman, had become concerned that semiconductor companies were “priced for perfection” following a multi-year up-cycle, so the manager took profits in some stocks and added incrementally to areas such as retail. An example is Nike, purchased early in 2017 having become “very cheap” on a relative basis after a poor 2016.

Over the year to 31 March 2017, the largest change in exposure has been to banks, which have gone from a significant underweight to a neutral position versus the benchmark. This has been partly as a result of increasing the allocation, but also because of strong performance since late 2016, generating a large degree of alpha for the portfolio. Healthcare exposure has decreased from an overweight to a neutral position, while the largest overweight versus the benchmark is now in retail.

Favoured retail stocks include ASOS and Autotrader in the UK, and Kroger, Lowes and TJX in the US. Huysinga comments that Kroger, a price-conscious food retailer, has an excellent management team and track record but has been hit by competitive pressures from Aldi – which has been ramping up its US network, sparking a price war with Wal-Mart – and the entry of Amazon to the groceries market. With food price deflation likely to reverse, Huysinga sees better times ahead for Kroger. Lowes is a DIY store that fits with Huysinga’s thesis that in a tight housing market, people are more focused on home improvement. The manager comments that while Lowes is a little riskier than Home Depot, which is a high-quality competitor with a great management team, investors are paid to take the risk. TJX is the parent company of TK Maxx (known as TJ Maxx in the US). Away from the US, Huysinga has also added Magnit, a Russian food retailer that had performed poorly owing to macroeconomic pressures; with the IMF forecasting that Russia will return to economic growth in 2017, discretionary spending could also recover.

After a poor period for the JPGI investment process, in which equity investors drove up the prices of highly valued ‘defensive’ stocks and avoided those perceived to be vulnerable to near-term volatility, there has been a significant turnaround since mid-2016. The fact that the trust predominantly hedges its currency exposure back towards the MSCI AC World Index benchmark weightings, where the UK makes up just under 6%, means there has been a noticeable boost from the weakness of sterling. However, share price and NAV total return outperformance of the index in all the periods shown in Exhibits 5 and 6 also illustrates the extent to which the trust has participated in the cyclical recovery that followed the UK’s EU referendum and the election of Donald Trump as president of the US.

Huysinga points out that in mid-2016 the relative performance of the cheapest versus the most expensive quintile of stocks on a rolling 12-month basis was the worst it had been since the global financial crisis. However, the second six months of the year saw stocks with high dividend cover, low price/book ratios and low forward P/Es outperforming the MSCI World Index appreciably.

At 19 June 2017, JPGI’s shares traded at a 1.6% discount to cum-income NAV. This is substantially narrower than both short- and longer-term averages: over one, three, five and 10 years, the cum-income discount has averaged 7.2%, 7.8%, 7.4% and 6.3%, respectively. The discount has narrowed sharply since the third quarter of 2016, arguably as a result of the higher distribution policy as well as a period of strong performance. The board has an informal policy under which it may use share buybacks to maintain the discount at a maximum of c 5% in normal market conditions. Given the recent narrowing, as well as the market dislocation that followed the UK’s EU referendum in mid-2016, there have been no buybacks so far in FY17.

JPGI is a conventional investment trust with a single share class. At 19 June 2017, there were 123.7m shares in issue. A five-for-one share split took place in January 2016 with the aim of increasing liquidity in the shares and facilitating regular saving and dividend reinvestment. The board may buy back up to 14.99% of shares or allot shares up to the equivalent of 10% of the share capital each year in order to manage a discount or a premium. No shares have been issued or bought back during FY17. Gearing is permitted in a range of 5% net cash to 20% geared. JPGI has a £25m multi-currency borrowing facility, which was fully drawn at end-H116; the current net gearing figure of 6.0% (at 30 April) suggests the loan remains fully deployed. JPMorgan Funds, JPGI’s Alternative Investment Fund Manager (AIFM), receives an annual management fee of 0.4% of assets less current liabilities. A performance fee of 15% of NAV outperformance of the benchmark may also be paid, subject to a hurdle of 0.5% above the benchmark return. Payment of performance fees is spread equally over four years, with fees accrued but not paid reduced by any underperformance in subsequent years. No performance fee was paid in FY16, but it seems likely given JPGI’s recent performance (see Exhibit 5) that a performance fee may be earned in respect of FY17.

With effect from FY17, JPGI has adopted a new distribution policy, aimed at satisfying investors’ desire for income within the context of a growth-focused investment strategy, as well as keeping the discount to NAV to a minimum. Starting from 30 June 2017, the trust will pay out at least 4.0% of year-end NAV as a distribution, paid in four equal instalments in October, January, April and July. The previous policy was to pay dividends that broadly reflected revenue earnings for the year. FY17 has been a transitional year, with a final dividend of 3.2p paid in October in respect of FY16 (unchanged on FY15’s 16p dividend, after adjusting for the stock split in January 2016), and three dividends of 2.2p each paid in January, April and July, making a total paid during the year of 9.8p (4.0% of the 30 June 2016 NAV), which is a dividend yield of 3.2% based on the 19 June share price.

Because the investment process is unchanged and previously resulted in adjusted annual dividends of c 3p per share in each of the last four years (a yield of 1.0% based on the current share price), it is likely that in future, in order to meet the 4.0% target, some of the distribution will need to come from capital rather than revenue returns. JPGI also has a substantial revenue reserve, which stood at £14.2m at end-H117, sufficient to cover the FY17 dividend 1.17x.

As well as offering a higher level of income, JPGI’s board views the certainty of income that comes from declaring the dividend at the start of the year as a key attraction for investors.

Since July 2016, when it adopted its higher distribution policy, JPGI has been a constituent of the Association of Investment Companies’ Global Equity Income sector, a relatively small peer group of eight funds. The trust ranks first in the sector for NAV total return performance over one, three and five years and since adopting the global focus strategy in October 2008. While it is worth noting that for the majority of the periods under consideration, JPGI was a member of the AIC’s Global Growth sector, it was a change in the trust’s distribution policy rather than its growth-focused investment approach that prompted its move into the income peer group. JPGI has the lowest ongoing charges in the sector, but is also one of only three trusts to levy a performance fee. The slight discount to NAV compares to a small average premium for the peer group, while gearing is broadly in line with the weighted average. JPGI currently yields less than the weighted average for the sector; although under its new distribution policy the trust pays a dividend equal to at least 4.0% of its year-end NAV per share, the 48.7% rise in the share price since the 30 June 2016 year-end has reduced the dividend yield to 3.2% based on the current price. The weighted average dividend yield for the peer group is currently 3.5%.

JPGI has four non-executive directors, all independent of the manager. Nigel Wightman joined the board in 2010 and was appointed chairman in 2015. Jonathan Carey, chair of the remuneration and audit & management engagement committees, has been a director since 2009. Gay Collins was appointed in 2012 and is the senior independent director, while Tristan Hillgarth joined the board in 2014. The directors have professional backgrounds in investment management and PR/communications.

Exhibits 10 and 11 show JPGI’s performance in New Zealand dollar terms. NZ dollar investors have enjoyed the same magnitude of outperformance of the benchmark as sterling investors since the middle of 2016, owing to the strong recovery in the value stocks in which JPGI invests. However, given the weakness of sterling since the Brexit referendum, which has boosted returns for UK investors in overseas stocks, absolute returns for NZ dollar investors have been lower (share price +23.0% and NAV +17.6% over 12 months to 31 May versus +48.6% and +39.1% for sterling investors).