The Brunner Investment Trust — Update 29 September 2016

Share prices have rallied strongly over the last three years, led by US stocks (Exhibit 2, left-hand side). Having sold off post the result of the UK’s EU referendum, global share prices have subsequently recovered. Stock markets have been volatile in 2016, and this trend could continue ahead of the US election and debate surrounding the timing and magnitude of US interest rate hikes. This could lead to a period of stock price consolidation. Looking at valuations of global stocks as shown by the Datastream World index (Exhibit 2, right-hand side), on a forward P/E basis, equities are close to the top of their 10-year range and are 17% higher than the average over this period. Dividend yields are broadly in line with the average. There is room for the RoE to improve over time, as although it has recovered from the depths of the global financial crisis, it is still nearly 50% off the high level of the last 10 years and 24% below the 10-year average. For investors wishing to have exposure to global stock markets, a fund invested in a high-conviction portfolio of quality, dividend-paying companies may hold appeal.

BUT was launched in 1927 to manage the wealth of the Brunner family following the sale of Brunner Mond & Co, the largest of four companies that combined to become Imperial Chemical Industries. It is managed by Lucy Macdonald, chief investment officer for global equities at AllianzGI. Prior to 23 June 2016, Macdonald was co-manager of the trust alongside Jeremy Thomas. The portfolio comprises UK and international equities aiming to generate long-term growth in capital and income; in recent years, the fund has become more concentrated. Since 2008, the benchmark has been a 50:50 split between the FTSE All-Share and the FTSE World ex-UK indices. Following a reduction in BUT’s UK equity exposure, there is a proposal scheduled for the March 2017 AGM to consider a change in the benchmark. Dividends are paid quarterly and the annual dividend has increased for the last 44 consecutive years. The interests of the manager and other shareholders are aligned; Lucy Macdonald has a significant amount of her pension invested in BUT.

The manager comments that in the current low-growth environment, dividends form an important part of total shareholder return and that successful active portfolio management can lead to superior performance. This is an important consideration, given that global stock markets have rallied since the Brexit vote sell-off, leading to valuations that look stretched in the short term. Low growth is expected to continue for a considerable time; it is difficult to envisage much further monetary easing and there is debate regarding the timing of higher interest rates in the US. Corporate profits are modest and are meeting reduced earnings expectations, which implies a lack of potential stock market momentum from positive surprises. The manager suggests that in this environment investors will benefit from focusing on concentrated, conviction portfolios like BUT.

A lot of exposure within the BUT portfolio is in technology businesses, which are generating higher-than-average growth. However, this is not just in the traditional areas – the manager opines that technological trends are prevalent across a broad range of sectors including selected parts of industrials, consumer and healthcare, but is stock specific. She believes that in the future most stocks will essentially become technology stocks and that as a result, index sector classifications are becoming less meaningful.

BUT is managed on a bottom-up, stock selection basis, while taking account of the prevailing macro environment. Quality stocks are selected for their balance of capital growth and income, based on in-depth fundamental research. Potential portfolio companies are quantitatively screened to determine style characteristics and upside potential. Running a concentrated portfolio, the manager is able to draw on the strengths of AllianzGI with its broad team of fund managers, analysts, GrassrootsSM (a proprietary market research network) and ESG expertise. Before the change to a single manager, BUT consisted of two portfolios, one of UK and one of international equities; it is now managed as a single global portfolio, with a consistent investment style. Over time, exposure to the UK has been reduced in favour of overseas equities to diversify the income stream and provide access to higher growth in dividends. Despite volatility in global stock markets in 2016, portfolio turnover remains low.

BUT’s portfolio is diversified by geography and sector; at the end of August 2016, the top 10 positions accounted for 22.7%, which is a modest increase in concentration from 19.8% 12 months earlier. The number of positions has been reduced over time and there is scope for the portfolio to become even more concentrated; there are currently 70 holdings.

As shown in Exhibit 3, the reduction in UK exposure has continued; funds have primarily been reinvested in Europe ex-UK, North America and Pacific ex-Japan. There has been a reduction in high-yield/low dividend growth stocks; positions in Barclays, GlaxoSmithKline and Royal Dutch Shell have been sold or reduced and underperforming UK positons in Brammer and Tesco have been sold. A new position has been initiated in US-listed electronic component manufacturer Amphenol. The manager expects the company to generate double-digit revenue growth from increasing its market share and via acquisitions; it has acquired the Advanced Sensors business from GE, which broadens its addressable market. Earnings should grow faster than revenues as a result of margin expansion and share repurchases.

The largest holding in the portfolio is Microsoft. The manager has held the stock for a long time, but still has high conviction that its share price has further upside. It is one of the large previously non-paying technology companies that now offers both yield and growth in dividends. Microsoft has a good mix in its business between business and consumer. Azure, the cloud platform, is growing strongly and Microsoft continues to have a strong presence in gaming; the manager considers that this business is undervalued given recent revaluations of competitors Activision Blizzard and Electronic Arts.

Exhibit 4 shows sector exposure as at the end of July 2016. Over the previous 12 months there have been modest changes, with the largest increases in financials and technology and the largest decreases in cyclical sectors oil & gas and industrials. Industrials is the largest overweight sector and offers exposure to a wide variety of end-markets. Holdings include Nielsen, whose media analytics allows customers to assess the value generated by their advertising spend. Automation is a growing subsector within industrials and is represented in the portfolio via holdings in Flowserve and SMC. The manager is modestly underweight the large financial sector as she considers the industry is challenged. In the banking sector there is little top-line growth; there will be continued restructuring and consolidation and the insurance sector will find growth difficult in a low interest rate environment. In financials, the manager favours asset managers, where volume growth is in line with GDP. Pension provisions are shifting more towards the individual and the money created from quantitative easing has to be managed somewhere. BUT has a holding in UBS, which has sold off most of its investment banking operations and has significant asset management exposure, including in Asia, which is the largest area of wealth creation.

BUT’s absolute returns in recent months have been very strong assisted by the boost to overseas equities as a result of the fall in the value of sterling following the Brexit vote. Over the last six months, BUT’s NAV and share price total return have been 16.6% and 19.9% respectively. Its share price has outperformed the benchmark over this period. The largest positive contributors were positions in Germany-listed companies Adidas (apparel & footwear), where the position is being trimmed following a period of share price outperformance, and Covestro (chemicals), US-listed Microchip Technology (semiconductors) and from not holding BT (telecoms). The largest two detractors to performance were both UK companies: Mothercare (specialist retail) and Brammer (industrial distribution).

Looking at relative returns in Exhibit 6, BUT’s NAV total return has outperformed the benchmark over five years. As a reference to UK shareholders, the benefits of having international equity exposure are shown by BUT’s share price and NAV total return outperformance versus the FTSE All-Share index over all periods shown.

BUT’s shares are currently trading at an 18.0% discount to net asset value (Exhibit 9, cum-income with debt at fair value). This is wider than the 14.2% average of the last 12 months (range of 7.9% to 20.8%); the widest discount was on 9 August 2016 in the post-Brexit period, during which time investment trusts have generally experienced wider discounts. The current discount is also wider than the averages over the last three, five and 10 years of 13.2%, 12.9% and 12.8% respectively.

Given BUT’s structural gearing, highlighted in the following section, it is sensible to consider the discount with debt at par value (Exhibit 8); this tends to be higher than with debt at fair value as the market value of the debt is higher than the par value.

BUT’s discount should narrow as the debt reaches maturity. It may repurchase 14.99% of its shares annually and allot up to 10%; however, these powers have been used sparingly. The last significant activity was in FY11, when 2.0m shares were repurchased at a cost of £8.3m.

A conventional investment trust, BUT has 43.0m ordinary shares in issue. It has structural gearing of c £50m in the form of a £18.2m stepped interest rate loan with an effective interest rate of 11.27%, repayable on 2 January 2018, a £28.0m fixed-rate loan with an effective interest rate of 9.25%, repayable on 20 May 2023 and £0.5m in 5% cumulative preference stock. Compared to the current environment of low interest rates, the cost of BUT’s debt is relatively high. The board has considered all options for early repayment and concluded that this would be uneconomic.

AllianzGl receives an annual management fee of 0.45% of net assets minus short-term liabilities and excluding any funds managed by AllianzGI. Ongoing charges for FY15 were 0.75%, versus 0.79% in the prior year.

BUT has a progressive dividend policy and annual dividends have been increased in each of the last 44 consecutive years. Since FY14, dividends have been paid quarterly, in June, September, December and March; the compound annual growth rate over the last five years is 4.6%. The FY15 annual dividend of 15.3p was a 2% increase over the previous year and required a modest contribution of 1.2p from revenue reserves. However, after payment of the final dividend in FY15, revenue reserves remained strong at 22.6p per share. BUT’s current dividend yield is 2.7%.

In Exhibit 10 we have compared BUT to a selected group of trusts in the AIC Global sector that have between 25% and 50% exposure to the UK. BUT is ahead of the peer group average over one year, but behind over three, five and 10 years. In terms of risk-adjusted returns as measured by the Sharpe ratio, it is above the peer average over one year and below over three years. The discount is the widest in the peer group and the ongoing charge is modestly wider than average, which may be due to the maintenance cost of the debentures. BUT has a higher dividend yield than the peer group average, ranking second out of the selected group of nine closed-end funds.

There are five non-executive members on the board of BUT. Chairman, Carolan Dobson was appointed in December 2013 and assumed her current role in March 2016. Ian Barlow is chairman of the audit committee; he joined the board in November 2009. Vivian Bazalgette is senior independent director and chairman of the remuneration committee, and he joined the board in January 2004. The other two board members and dates of appointment are Peter Maynard (October 2010) and Jim Sharp (the newest member of the board, January 2014).