The Scottish Investment Trust PLC — Update 18 November 2016

So far in 2016, global stock markets have been volatile, but many indices are trading at or close to historical highs, suggesting that the protracted low interest rate environment and monetary accommodation is continuing to force investors into risk assets in order to secure a return. As shown in Exhibit 2 below (left-hand chart), total returns from the main UK and World indices over the last four years have been sufficient to make the pain of the global financial crisis look little more than a blip. UK-based investors have seen a particular boost to the value of overseas holdings owing to the weakness of sterling since the EU referendum in June.

As shown in the right-hand table, however, 12-month forward P/E valuations across most regions are well above long-term averages, with only Asia and Japan close to or below the 10-year mean. With stock markets arguably looking expensive in aggregate, investors may prefer an actively managed fund, where managers can avoid pockets of overvaluation in favour of stocks with greater recovery potential, rather than an index-tracking fund. Dividend yields in all markets remain attractive relative to cash and bonds, and could provide an important source of return in an environment where further price appreciation may be harder to achieve.

The Scottish Investment Trust (SCIN) was established in 1887 in Edinburgh. It began with assets of £500,000 and invested in a global portfolio of bonds and shares, including significant exposure to Latin America and railway stocks. Some of the original investments will be familiar to investors today, including Standard Life and the investment trusts Scottish American and Mercantile.

Still based in Edinburgh, the trust is self-managed and also operates a savings scheme, through which its investors can hold SCIN shares in a range of wrappers including ISAs and children’s savings plans. Over the last three years, the trust has streamlined its operations, cutting costs, outsourcing administrative functions and reducing the size of its investment team to four, which the manager says has facilitated the new, more focused investment approach (see page 4). SCIN’s manager Alasdair McKinnon, who has been with the trust since 2003, is supported by deputy manager Martin Robertson (who joined in 2004) and investment analysts Sarah Monaco and Mark Dobbie, both of whom have worked at SCIN since 2000.

SCIN aims to achieve above-average returns by investing in an international portfolio of equities, and also aims to grow its dividend ahead of the rate of UK inflation. Dividends have been maintained or increased every year since 1982. The new investment approach, in place since October 2015, is centred on a contrarian view, with the manager seeking to exploit the behavioural biases of investors and, to echo the words of Warren Buffett, “be greedy when others are fearful and fearful when others are greedy”. There are typically 70-120 stocks in the portfolio.

There is no formal benchmark, but the trust uses the FTSE All-World and FTSE All-Share as reference indices, and also measures its performance against a group of global peers.

Manager Alasdair McKinnon describes the recent changes to the SCIN team and process as a way of addressing the need for the trust to evolve for the next hundred years. Having a more focused team and a smaller cost base is seen as positive for the trust’s shareholders, both from the point of view of a reduction in ongoing charges, and the organisational benefits of having a close-knit team who understand how each stock fits into the portfolio and are focused on maximising returns.

While portfolio construction is driven by stock selection, the cycles of sentiment and capital that the manager considers when choosing stocks are influenced by the macro environment as well as company-specific factors. For the SCIN team, the biggest macro challenges centre on the global financial system and high levels of debt. McKinnon points out that since the financial crisis, accommodative monetary policy has benefited asset prices but not wages, leading to high levels of disaffection in the workforces of deindustrialised western economies, which finds expression in support for populist political movements.

The manager sees no imminent prospect of a normalisation in interest rates, given the role of debt in the global economic recovery so far; raising rates could choke off the improvement as well as cause a debt crisis, as seen in the eurozone in 2011. Any sign of weakness in the economy or stock markets tends instead to be met with further accommodation, as with the post-Brexit rate cut by the Bank of England.

McKinnon says inflation may be the key to shaking off the lingering post-crisis malaise, with the first signs of a retreat from the low-inflation mantra visible in the increased willingness of the UK, US and Japanese governments to boost the economy through fiscal rather than monetary expansion. A degree of inflation in the system would be positive for both companies and consumers, leading to higher wages and easing the burden of debt servicing.

SCIN’s investment process has been refreshed under the new management team in place since late 2015 and the trust now follows an investment style the manager describes as ‘global contrarian investing’. Broadly, this indicates a focus on companies that have been overlooked by other investors and the investment team uses behavioural finance analysis to identify points in the cycle where market sentiment may be unduly optimistic or pessimistic. McKinnon says investors have a tendency to fall in love with companies that have done well and avoid those that have done badly; SCIN’s approach is to seek to do the opposite and buy those stocks that are out of favour but have the potential to become more loved, while selling those that have less scope to do so.

The four-strong investment team monitors the global stock universe, using inputs such as newspaper articles and broker communications, as well as meeting companies, attending conferences and simply observing the world around them. They explain that their Edinburgh base provides a wealth of opportunities, as many company management teams visit the city but there is less competition for meetings than in London.

As SCIN is a low-turnover portfolio (c 15% year-to-date), McKinnon points out that the investment team is not seeking to identify a large number of new investment ideas at a time, although they may keep some in reserve. “The biggest cost and the reason most active managers underperform is that they trade too much,” he says, adding that fund managers tend to do better when they stick to their guns and avoid any pressure to ‘do something’.

When an interesting idea is identified, the team starts with an assessment of the stock’s position in the cycle of sentiment (from optimism to euphoria; anxiety, denial and panic to capitulation; despondency and depression to hope, relief and back to optimism).They seek to understand where other investors are in the cycle before taking a position, and will tend to avoid those companies that are universally loved, preferring to invest at the point of maximum pessimism. The team also identifies the position of a company in its capital cycle, which is a means of assessing the behaviour of management.

If the entry point is judged to be attractive, the team will undertake valuation work on the stock, identify the drivers of the business, the yield and sustainability of the dividend, P/E ratio and the cyclical earnings position. As a small team, all the members are expected to understand each of SCIN’s holdings, although one team member will take the lead for each stock or idea, undertaking the detailed modelling work. The end portfolio typically contains 70-120 stocks, although McKinnon says the preference is to keep to the lower end of the range in order that each stock can have a meaningful impact.

The investment team split the stocks they invest in into three broad categories:

Examples of ‘ugly duckling’ stocks in the portfolio include top 10 holdings GlaxoSmithKline (GSK) and Sands China. McKinnon comments that GSK has performed poorly for more than a decade, following a wave of patent expiries on its leading drugs and a lack of new blockbusters to take up the slack. Innovation cycles in pharmaceuticals can be protracted, owing to the time it takes to develop and test new treatments. However, SCIN’s manager sees potential in GSK’s pipeline, which could boost earnings from their current depressed level, and meanwhile its dividend yield of c 5% is attractive. While there was a consensus view in the market that the dividend might be under pressure, the SCIN team analysed GSK’s financial position in depth and was satisfied it could be sustained for a number of years, giving them the confidence to take a significant position in the company. GSK has performed strongly since the EU referendum (+16.5% in share price terms from 23 June to 19 October), owing to its large proportion of foreign earnings; SCIN’s manager says this illustrates how quickly sentiment towards very out-of-favour companies can turn, even in the absence of any particular operational newsflow.

Sands China operates casinos in Macau, an area that had performed very strongly until the slowdown in the Chinese economy and the government’s clampdown on corruption, which has affected areas connected with what might be viewed as conspicuous consumption. In the long term, SCIN’s manager views the development of Macau as a holiday destination on a par with Las Vegas as an attractive structural story, supported by infrastructure improvements such as the construction of a bridge to Macau from Hong Kong. In the meantime, Sands has a dividend yield of c 6%, which the investment team is confident can be sustained, and which may prove sufficiently attractive to the market to prompt a reassessment of the company’s prospects.

Rentokil Initial was bought in 2015 following a restructuring that saw it refocus on its core pest control business. Competitors in the US trade on much higher ratings and have followed a strategy of buying up independent businesses and consolidating them on a state-wide basis, which is something Rentokil is now doing. Filling the gaps in its network through acquisition will make the company more competitive, and should result in a rerating to a level comparable to its peers. The company had suffered from negative perceptions as a formerly high-growth stock that had expanded too aggressively into new business areas in the 1990s.

UK water companies offer a clear, transparent and non-political regulatory model and RPI-linked dividends. Infrastructure as a whole is in favour with investors because revenues are predictable for years to come and are guaranteed by government. However, McKinnon points out that increasingly utilities are finding a home in infrastructure or private equity funds rather than as quoted entities, with only three out of the 10 originally privatised UK water companies still listed on the stock market. In time, the manager says it may be more efficient for Severn Trent and United Utilities (also in the SCIN portfolio) to be owned by a private equity or infrastructure fund, which could lead to attractive takeover premiums; in the meantime both companies have dividend yields of c 4%.

The sell discipline is the opposite of the path to buying a stock: if the earnings cycle, management and investors are all optimistic, there is little margin for error and there are likely to be better opportunities elsewhere. Holdings may also be sold on the basis of fundamental issues. Recent sales include UK housebuilder Persimmon, sold before the EU referendum because of the downside risk from a vote to leave; Danish jewellery firm Pandora, which the manager felt had become expensive and was vulnerable to changing fashions; and Associated British Foods, which was highly priced, vulnerable to Brexit sentiment and faced a static couple of years because of heavy investment in expanding Primark into the US.

At 30 September, SCIN was positioned at the lower end of its range of c 70-120 stocks. This ranks it as one of the more concentrated portfolios in its peer group of global funds. The top 10 stocks made up 29.6% of the total portfolio, which is slightly above the peer group median.

The portfolio is not constructed with reference to a benchmark in terms of either sector or country weightings, but is instead an expression of the team’s best ideas globally. This is evident in the sector weightings shown in Exhibit 3, which differ widely from the FTSE All-World index weightings. Oil & gas, telecoms and utilities are notably overweight, while there are underweights in technology, financials, healthcare and consumer goods.

In geographical terms, there is a bias to the UK, which makes up nearly one-third of the portfolio compared with less than 10% for most global indices. The manager points out that most of the UK holdings are international businesses where, for example, a US competitor could as easily be held, but two factors favouring an overweight UK position are the higher dividend yield and the current weakness of sterling, which benefits companies with overseas earnings. The flipside to the UK overweight is a large underweight to the US, which makes up more than half of most global indices.

While stock selection is bottom-up, there are certain themes in the portfolio. These include e-gaming, where the team has bought Nintendo in preference to the more highly rated US competitor, Electronic Arts or graphics chip maker, NVIDIA. With the decline in mass TV and increased broadband penetration, online gaming is rising in popularity as a leisure activity, and McKinnon sees it as having the potential to be the ‘next Hollywood’. Having been out of favour for many years, partly owing to a poor performance in consoles, Nintendo has performed well recently on the back of its connection with Pokémon Go, and the launch of a new Super Mario game for the iPhone underlines the value of the company’s intellectual property. Nintendo is also a factor in SCIN’s holding in Bank of Kyoto, part of a Japanese financials theme. The bank has a large equity portfolio, the value of which was equal to its entire market capitalisation when SCIN bought the position, and its largest holding is a 4% stake in Nintendo. McKinnon comments that at the purchase price, “we were essentially getting the banking operations for nothing”.

Since the change in investment approach, sales include Alphabet (the parent company of Google), Apple and Amazon, as well as a number of smaller tech stocks that were plays on the Apple and Android supply chain. With smartphone penetration at high levels and new models offering only small incremental improvements, McKinnon says the boom for the sector is over, and the likely slowdown in sales could bring to light problems of overinvestment at some companies.

SCIN does not have an official benchmark, but measures its performance with reference to the FTSE All-World and FTSE All-Share indices. Neither is a perfect comparator; while the FTSE All-World index is a global index covering both developed and emerging markets, which chimes with SCIN’s investment approach, it has only 6.5% in the UK, compared with 32.8% for the SCIN portfolio.

As shown in Exhibit 5, in absolute terms performance has been positive over both the short and longer term, with share price and NAV total returns of c 11-13% a year over three and five years. Performance has been particularly strong over six months and one year, buoyed by the fall in sterling, which has increased the value of overseas assets for UK-based investors.

As shown in Exhibit 6, SCIN has outperformed the FTSE All-Share in both share price and NAV total return terms over all periods shown, underlining the value for UK investors of allocating some of their assets to overseas markets. Exhibits 6 and 7 show a more mixed track record versus global indices, although recent performance has been favourable.

At 15 November 2016, SCIN’s shares traded at an 11.0% discount to cum-income NAV with borrowings at fair value, or a 9.0% discount to ex-income NAV with borrowings at fair value. As noted below, the low level of interest rates causes the market value of the trust’s fixed borrowing to rise, which reduces the NAV; therefore the discount with borrowings at fair or market value is narrower than the discount with borrowings at par or book value.

SCIN uses share buybacks to narrow the discount when it exceeds c 9% (based on the ex-income NAV with borrowings at fair value). In the past 12 months the trust has bought back and cancelled 9.2m shares at a cost of £59.9m. Over this period the ex-income discount has averaged 10.2%, a little wider than longer-term averages (c 9-9.5% over three, five and 10 years).

Somewhat perversely, strong performance caused the discount to widen in September and early October, as the share price lagged the rising NAV. However, the share price has now caught up and since the UK’s EU referendum on 23 June, the NAV total return has been 20.5%, the share price total return has been 21.0% and the ex-income discount has averaged 10.4%. Given the relatively recent adoption of the new investment strategy, it may be the case that investor perceptions are still based on the longer-term performance record, which had been lacklustre. If the improvement in performance can be sustained, there is scope for the discount to narrow from the current level, further supported by the board’s willingness to act through share buybacks.

A conventional investment trust with a single class of share, SCIN had 96.3m ordinary shares in issue at 15 November 2016. The trust has the authority to buy back up to 14.99% of the share capital annually in order to manage a discount to NAV, and employs these powers with the aim of maintaining the discount (based on ex-income NAV with borrowings at fair value) at or below 9% in normal market conditions.

Gearing is principally via a 30-year issue of secured bonds, taken out in 2000 for £150m with a coupon of 5.75%. (There is an additional £2m of perpetual debenture stock with coupons of between 4% and 5%.) As part of a tender offer in 2006, £42m nominal of the secured bonds were bought back, and in H116 a further £21m nominal, or 20% of the outstanding borrowing, was bought back at a cost of £28.2m. While the coupon on the secured bonds looks relatively competitive compared with the long-standing debt of some investment trust peers (particularly those facilities arranged in the 1990s), the continued low interest rate environment has the effect of increasing the market value of the borrowings, which puts downward pressure on the fair value NAV. At H116, the par value of the borrowings was £83.6m, meaning that the gross gearing (based on 15 November net assets) is c 10.1%, compared with a ceiling of 20%. Net gearing at 30 September was 5.2%.

SCIN delegates the role of Alternative Investment Fund Manager (AIFM) to its subsidiary SIT Savings, to which the investment team (all employees of the trust) are seconded. Because it is self-managed, SCIN does not pay a management fee. Its total expenses for FY15, including staff costs, administration, legal and professional fees, were £4.9m, translating to an ongoing charges figure (OCF) of 0.52%. During H116, the trust outsourced some of its administrative functions, which should result in a further reduction of costs for FY16. SCIN already has one of the lowest OCFs in the investment trust universe.

SCIN pays dividends twice a year, in July and January/February. Dividend growth is a key part of the investment objective and the trust aims to increase its dividend year-on-year by more than the rate of UK inflation. SCIN has maintained or grown its regular dividend each year since 1982 and has also paid special dividends in 1999, 2002, 2007, 2008, 2013 and 2015. As shown in Exhibit 10 below, long-term regular dividend growth has been well ahead of inflation, beating RPI in all but two years since 1982 – in 1990 and 2011, both years when inflation was high in relation to stock market returns.

For FY15, a regular dividend of 12.5p was paid (5.0p interim and 7.5p final), with a 3.5p special dividend bringing the total to 16.0p. This equates to a yield of 2.15% based on the 15 November share price of 744p. So far for FY16, an interim dividend of 5.25p has been paid, an increase of 5.0% on the same period last year. At the half-year to 30 April 2016, SCIN reported that sterling weakness had boosted its income by 15.7% compared to a year previously; the fact that the pound has fallen further since then suggests that income for the full year may also be higher than FY15, so it is reasonable to assume that total dividends for FY16 will be at least as high as for the previous year.

While the trust is classified in the AIC Global (formerly Global Growth) sector, SCIN’s investment team does consider the dividend yield on stocks when assessing potential investments, particularly in the most out-of-favour (‘ugly and hated’) stocks, where a high yield means they will be ‘paid to wait’ for a recovery in the share price.

SCIN’s dividends (regular and special) have been fully covered by income in four of the last five financial years, and the trust had revenue reserves (after allowing for the final and special dividends) of £39.8m at FY15, sufficient to fund the regular dividend at the same level for more than four years.

SCIN is a member of the Association of Investment Companies’ Global sector, a large peer group of 26 funds with almost £20bn of assets. Exhibit 11 below shows a subset of the sector (the group against which SCIN measures itself), made up of some of the longest-established and largest peers. While all the peers invest internationally, they differ widely in focus, with between c 3% and c 40% invested in the UK and c 25-60% in the US. SCIN’s UK exposure is towards the top end and its US exposure towards the bottom end of this range.

While its longer-term returns lag the peer group, SCIN’s more focused and contrarian investment approach is arguably becoming evident in its shorter-term performance, where it ranks second for NAV total returns over one year. Risk-adjusted performance as measured by the Sharpe ratio is above peers over one year and a little behind over three years. SCIN’s dividend yield (including special dividends) is among the highest in the group, while its ongoing charges (which have fallen as a result of streamlining the investment team) are the joint-lowest; there is also no performance fee. Net gearing is a little below average. The discount to NAV, which is the third-widest in the group, may reflect SCIN’s relatively expensive structural borrowings – a feature shared by the one trust currently at a wider discount – or a perception lag given the relatively recent revamp of the team and investment process.

SCIN has six non-executive directors, four of whom have been appointed in the past three years as part of the process of modernising the trust. Chairman James Will joined the board in 2013 and assumed his current role in January 2016 following the retirement of Douglas McDougall. Hamish Buchan has been a director since 2003, while Russell Napier was appointed in 2009. Ian Hunter joined the board in 2014 and the two newest directors, Jane Lewis and Mick Brewis, were appointed in 2015. The directors have backgrounds in stockbroking, investment management, accountancy and law and most have professional experience in the investment companies sector.