Securities Trust of Scotland — The Trojan horse

In September 2020, the board of STS announced the appointment of Troy AM as the trust’s manager. The previous manager was Martin Currie, who launched the trust in 2005.

STS aims to achieve rising income and long-term capital growth through the investment in a balanced portfolio of global equities. The named fund manager, James Harries, supported by the assistant fund manager, Tomasz Boniek, employs an actively managed global equity income strategy with a focus on generating low volatility returns. The concentrated portfolio of 35–55 stocks is constructed without reference to benchmarks and with careful consideration of the absolute risk posed by each investment. STS invests primarily in global equities but may also invest in investment companies, real estate investment trusts, collective investment schemes and warrants. Derivatives may be used for the purposes of efficient portfolio management, which includes the hedging of currency risk. The managers do not intend to hedge currency or use derivatives and will stick to investing in equities. The trust now operates a strict discount control policy that seeks to ensure that the shares trade at, or close to, NAV. Gearing is permitted up to 20% of net assets; at end-November 2020, net gearing was 6.0%.

Following a letter of resignation from the global income team at Martin Currie on 2 June 2020, and a subsequent review of the investment management arrangements for STS, the board announced the appointment of Troy AM as the trust’s investment manager on 17 September 2020. Martin Currie’s manager, Mark Whitehead, who ran STS from May 2016, and its income team was fully engaged in the management of the fund and the handover from the notice date until 1 December 2020, when Troy AM fully took over management of the trust. This ensured a smooth transition between the managers.

The trust’s name remains the same, as does its investment strategy. Troy AM will manage the fund to meet its joint global equities income and growth investment objective. Exhibit 2 below compares the trust’s current and previous features. The Troy AM team has restructured the fund and aims to run it as a quality growth and income portfolio.

Troy AM was set up in 2000 by Lord Weinstock and Sebastian Lyon and remains an independent, owner-managed boutique, aligned with investors. It has an independent board and adheres to strong governance principles. The company employs 38 people and has c £13bn of assets under management (AUM) at November 2020, managing five strategies, including a global equity income strategy. Since inception, Troy AM’s investment focus has been on the preservation of capital and absolute returns. It invests in companies that it deems to be of high quality and that have a high return on invested capital (ROIC).

Troy AM has a proven track record of managing and growing investment trusts. Since being appointed, Troy AM has grown the shareholders' funds of Personal Assets Trust from £149m in October 2008 to £1.3bn in November 2020 and the shareholders' funds of Troy Income & Growth Trust from £47m in 2009 to £236m in November 2020.

The trust is managed by James Harries and Tomasz Boniek with the support of Troy AM’s wider investment team of 14 investment professionals. Harries is the fund manager responsible for Troy’s Global Income strategy. He has 23 years’ investment experience and has managed global equity portfolios since 2002.

Joining Troy AM in 2016 to establish the Troy Global Income Fund, Harries was previously a fund manager at Newton Investment Management, where he established and managed the Newton Global Income Fund. He was also the alternate manager on the Newton Real Return Fund. Under Harries’ management, the Newton Global Income Fund grew to c £4.5bn in AUM and was a top quartile performer in its sector over 10 years. Boniek has worked alongside Harries on Troy AM’s global equity income portfolios since 2017.

As the world is immersed in politics, including the recent US presidential election, Brexit and US-China trade relations, and pandemic management strategies, Harries and Boniek have been focusing on the current results from their portfolio companies. They believe that in the long run, companies’ sustainable cash flows and business growth will have much more of an impact on shareholders’ returns, than politics. They continue to monitor the investible universe, typically consisting of companies with high resistance to macroeconomic and political shocks, such as those caused by the COVID-19 pandemic.

Troy AM’s global income strategy applies a patient and disciplined capital allocation approach to create a concentrated portfolio of high-quality companies, purchased at attractive valuations and held for the long term. The team identifies exceptional global companies that can sustain growth and generate high returns on capital to compile an investible universe. These businesses have strong management teams that allocate capital effectively. Relative valuation is considered: the team selects attractively valued companies relative to similar investment opportunities.

Exhibit 3 illustrates Troy AM’s global income strategy characteristics relative to the MSCI World Index. These are based on the Trojan global income fund. The strategy has lower valuations with a P/E multiple of 17.2x versus 22.7x, a higher cash flow yield of 5.4% versus 4.1%, a higher operating margin of 25.6% versus 9.9%, a higher return on capital of 14.1% versus 4.9% and a higher ROE of 26.3% versus 8.8%.

Portfolio turnover is typically low (under 10% pa). Troy AM considers itself as an owner of businesses and buys equities to access their long-term futures, targeting compounding value over time.

The strategy seeks to deliver high-quality sustainable income from a diversified portfolio of high conviction stocks, aiming to grow the portfolio’s income steadily over time. The fund manager intends to derive income from the dividend distributions of the underlying portfolio and does not intend to use option writing as part of the income strategy. As a consequence, in the short term, the revised strategy will deliver a lower level of income than is currently received by the company, but the board believes that the long-term income growth prospects will be enhanced.

Troy AM’s team maintains a global income investible universe of around 200 stocks in its favoured sectors (shown in Exhibit 5a). The team monitors and updates the universe, using quantitative and qualitative screens. Ideas on candidate companies are presented to the fund manager. Each stock has a two-page review of its investment case. If the stock passes the selection criteria of the team, further research is undertaken including:

Troy AM’s team seeks businesses that should be insulated from ongoing disruption, have predictable growth, recurring revenues and high free cash flows. Exhibit 4 shows the characteristics of the type of company it seeks and some stock examples.

The team conducts ongoing reviews, including regular company meetings, and continuously stress tests the investment case of all the monitored companies. Portfolio managers are responsible for investment decisions and select stocks for the portfolio from the investible universe.

The STS’s investment approach is bottom-up, unconstrained in general and by any benchmark. Lipper Global - Global Equity Income Index is used as a reference index. Despite the high stock concentration, quality bias de-risk the portfolio to an extent, relative to a global basket of stocks. The following limits are set:

The company’s exposure to listed equities is set within a range of 90% to 120% of shareholders’ funds in normal circumstances. The team’s objective is to use gearing (up to 20% permitted) in a tactical way as valuations change.

Since being appointed on 12 November, Troy AM’s team extensively restructured STS’s portfolio within a few days. At 25 November 2020, the restructured portfolio had 33 holdings.

Exhibit 5b shows STS’s portfolio by sector exposure as at end-September 2020. Exhibit 5a illustrates the model portfolio compiled by Troy AM and highlights the change in the sector mix. Troy’s portfolio is more concentrated across seven sectors – those deemed by the team to have quality bias, with the top three being consumer staples (42.0%), healthcare (19.5%) and information technology (18.4%), compared with information technology (23.5%), communication services (14.2%) and consumer staples (12.2%) in the Martin Currie fund.

Geographically, Troy AM’s model portfolio also differs from the Martin Currie fund. Exhibit 6a and 6b illustrates Troy AM’s higher exposure to Europe (including UK) 46% versus 35% at Martin Currie and lower weightings in emerging markets and Asia (combined) at 2% versus 20% respectively.

Exhibit 7 presents the top 10 holdings. Troy AM’s model portfolio has a defensive consumer staples and healthcare tilt, with some technology, compared to wider sector representation at Martin Currie, with some dominance (four stocks out of 10) of the technology sector.

The trust is geared by approximately 6%.

STS’s former manager, Mark Whitehead, was appointed in May 2016 and adopted the trust’s current mandate on 1 June 2016. Performance was measured against the median of all relevant open- and closed-ended peers (sourced from the Lipper Global – Global Equity Income and AIC Global Equity Income sectors respectively) on a rolling three-year basis. Therefore, the most relevant performance figures to consider are five years and less. Exhibit 9 shows STS’s NAV outperforming its blended benchmark over three years and five years by 8.1% and 8.7%, respectively, on a total return basis.

We have also included the performance track record of the current fund manager, Harries, who has assumed responsibility for STS from 12 November 2020. We highlight the Trojan Global Income Fund, which was established and has been managed by Harries since 2016. Considering that the Trojan Global Income Fund is an open-ended vehicle and does not employ gearing, its performance has been very robust. Exhibit 9 illustrates that the Trojan Global Income Fund outperformed STS, on the NAV total return basis, over the three-year period by 2.5%. The Trojan fund underperformed STS’s NAV on a total return basis over one year and shorter periods, as Asian markets, China in particular, performed very strongly, and the fund has little exposure to China.

STS is currently trading at a 0.7% discount to its cum-income NAV. As shown in Exhibit 11, the previously persistent discount to NAV started to close in H219, and between December 2019 until the sharp market correction in March 2020, the trust consistently traded at a premium or close to NAV. The average discount over the past one and three years is 0.9% and 4.2%, respectively. The discount began widening from June 2020 following the news that former Martin Currie manager, Mark Whitehead, had resigned until September 2020, when the market positively received the announcement about Troy AM’s appointment. Since mid-September the discount has narrowed significantly and the trust has been trading at a narrower than 4% discount.

At the time of the handover to Troy AM, STS’s board introduced a discount control mechanism aiming to maintain the share price at around NAV. In 2019, in conjunction with Martin Currie, it significantly increased the marketing budget and activity, and in October 2018 it appointed Sarah Harvey as a director, bringing considerable marketing expertise. With the transition to Troy AM the board intends to sustain the marketing initiatives to promote the trust. It has the authority (renewable annually) to repurchase up to 14.99% of issued capital and to allot up to 5% to help manage the supply and demand for STS shares.

STS remains a conventional investment trust with one class of share; there are currently 104.7m shares in issue and 17.6m shares held in treasury. Reflecting the narrowing of the share price discount to NAV from H219, repurchase activity has reduced significantly. As shown in Exhibit 1, during FY20, the board repurchased 0.4m shares at a cost of £0.9m and so far in FY21, 0.7m shares have been repurchased at a cost of £1.5m. In FY19, 6.0m shares were repurchased, representing 5.3% of share capital. More recently, as shown in Exhibit 11, STS has traded at a premium to NAV and during FY21 the board issued 0.6m shares from treasury at a premium to NAV and at a cost of £1.3m. During FY20 the board issued 0.7m shares from treasury at a cost of £1.4m. Following the newly introduced discount control mechanism, the board intends to continue issuing shares when the trust trades at a premium to NAV.

The board introduced a discount control mechanism aiming to ensure that in normal market conditions the shares trade consistently close to NAV. The company will seek to buy back shares if they are trading at a discount to their underlying NAV and conversely will look to issue new shares if the company's shares are trading at a premium to their underlying NAV. The aim will be to protect shareholders from the company trading at a material discount to NAV, while also growing the fund through NAV-accretive share issuance at a premium to NAV.

The trust has a £15m seven-year, multi-currency, fixed-rate facility, alongside a £10m two-year revolving credit facility with the Royal Bank of Scotland. Gearing is permitted up to 20% of net assets; at end-November the trust had net gearing of 6.0%.

Troy AM will receive an annual management fee of 0.65% of STS’s net assets up to £750m, 0.55% of net assets between £750m and £1bn, and 0.50% above £1bn. As a contribution towards the costs of the change of investment manager, Troy AM will waive its management fee for a period of 12 months from its appointment, as well as making a significant ongoing annual contribution to the cost of the company secretarial and administration services.

The fee is paid 65:35 between capital and income respectively, reflecting the board’s expected long-term split of the fund’s capital gains and income. As at end-FY20 (March 2020), the trust’s ongoing charges were 0.9%.

STS’s investment objective is to deliver rising sustainable income as well as long-term capital growth. Troy AM’s strategy is to deliver future dividend payments from the revenue earned by the portfolio and these payments will not be enhanced by writing options. Anticipating an initially lower level of income from the revised strategy than was previously received by the company, the board decided to reset the dividend for the year to 31 March 2021 to a deemed to be more sustainable level of at least 5.5p per share. The board anticipates steady growth in dividends from the revised level, thus employing a progressive dividend policy.

Over the past 10 financial years to FY20, the dividend has grown at a compound annual growth rate of 3.3%, reflecting good appreciation in the level of dividends received from investee companies. The board also has the flexibility to pay dividends out of retained capital reserves, if necessary, with the aim of providing a rising and reliable income to STS’s shareholders.

Exhibit 12 shows the AIC Global Equity Income sector, which consists of six funds. The open-ended peer group comprises 53 funds and we show their averages for comparative purposes. STS remains one of the smallest funds among its peers, ranking fifth. The trust’s performance from June 2016 to the end of November 2020 was principally down to Whitehouse, Martin Currie’s manager. The most relevant NAV total return performance periods to consider are one and three years, where STS’s ranking slid to third for both periods (from second in April 2020).

We have also shown the performance of the new fund manager, Harries, using his Trojan Global Income fund. Its total return is competitive. The fund outperformed the average of the six closed-ended funds and the 53 open-ended funds over three-year period. Despite being an open-ended fund without the use of gearing, it also outperformed three of the six trusts over one year and four over three years.

STS’s ongoing charge of 0.9% is closer to high end in the group; but the new fee structure is likely to produce lower charge, going forward. There is no performance fee. The trust trades at a small discount around its cum-fair NAV, ranking fourth on the date shown. The newly introduced discount control mechanism is likely to keep the share price around the NAV level. STS ranks second on its level of gearing and fifth on its dividend yield (3.2%).

The board consists of four independent non-executive directors. John Evans (appointed February 2016) was appointed as chairman at the AGM on 17 September 2019. Angus Gordon Lennox is the senior independent director (appointed to the board in November 2013 and assumed his current role in July 2017). The other directors and their dates of appointment are Mark Little (October 2014) and Sarah Harvey (October 2018).