JPMorgan Global Growth & Income — Value-focused growth fund with 4% distributions

Following on from a strong 2017, global equity markets entered the new year in a mood of continued optimism. As shown in the chart below, sterling-based investors in global equity markets (as measured by the MSCI AC World index) have almost trebled their money in total return terms over the past five years, far outstripping the returns seen by those who invested only in the UK, as measured by the FTSE All-Share index. The global economy has enjoyed a period of synchronised growth, and company earnings beat expectations in 2017 for the first time in several years. The US corporation tax cuts will provide a further boost to earnings in the world’s largest stock market.

The corollary to this rosy scenario is that average stock valuations now look extended in many markets. As shown in the table below, US forward P/E ratios are 26% above their 10-year average, and price/book ratios are also high (the current 3.6x is a close to a 10-year high and 49% above the long-run average). While other markets are less egregiously overvalued (the current UK price/book ratio is actually below the 10-year average, for example), the overall level of valuations suggests that a valuation-aware investment approach may be advisable, particularly in an environment where monetary tightening and rising inflation could begin to put a brake on economic expansion.

JPMorgan Global Growth & Income (formerly JPMorgan Overseas) is the only retail investment vehicle offering access to J.P. Morgan Asset Management’s global focus investment approach, which it has followed under manager Jeroen Huysinga since October 2008. Originally launched in 1887, it is listed on the London and New Zealand stock exchanges, and aims to provide capital growth for its investors from a global portfolio of 50-90 attractively valued stocks with significant profit potential and clear catalysts for revaluation. In July 2016, JPGI announced a new distribution policy, aimed at boosting its appeal to income-seeking investors in a low interest rate environment. While continuing to invest primarily for growth, the trust aims to distribute at least 4.0% of its previous year-end NAV as a dividend in four quarterly instalments, announced at the start of the financial year in order to give investors greater certainty. The dividend may be funded partly out of capital (the portfolio yield has historically been between 1% and 2%) or from the revenue reserve.

JPGI is a member of the Association of Investment Companies’ Global Equity Income sector (which it joined from the Global sector following the adoption of the new distribution policy), and measures its performance against the MSCI All Country World index (ACWI). Gearing is permitted in a range from 5% net cash to 20% geared, and the trust has recently issued £30m of 30-year loan notes with a fixed coupon of 2.93%, locking in low-cost borrowing for the long term.

Huysinga is optimistic on the global economic backdrop, with synchronised growth around the world. He points to particularly strong trade growth (forecast at 3.6% for 2017 and 3.2% for 2018 by the World Trade Organisation, compared with an average of 2.2% for the previous four years), and favourable economic and business sentiment indicators (purchasing managers’ indices (PMIs) were in expansionary territory across developed and emerging markets in Q317). Capex intentions are extremely robust, particularly in the US, where merger and acquisition (M&A) activity could also accelerate in 2018 as a result of the recent US tax reforms. Furthermore, ambitious supply-side reforms in China have the potential to rebalance the economy, reduce pollution and improve the environment, without having a significant negative impact on growth.

The manager is closely monitoring risks to the outlook, and says that if the synchronised global recovery were to stutter, the logical starting point would be the US, which has enjoyed nine years of strong growth. Stock markets have historically peaked six months before the onset of a recession, but at present risk factors such as a peak in corporate profits, a downturn in employment rates, a change in the direction of leading indicators or a widening in high-yield bond spreads all appear muted. As a result, Huysinga sees decent growth in the US continuing for another 12-18 months, and longer in Europe and Japan (notwithstanding the risk of contagion from a US recession), where the recovery is at a much earlier stage.

Huysinga points to discipline among company managements leading to higher shareholder returns. Earnings growth surprised on the upside in 2017 for the first time in more than five years, and has the potential to reach double digits again in 2018. However, in spite of value companies generally having better earnings momentum than growth companies, the market has disproportionately rewarded growth stocks such as the FAANGs (Facebook, Apple, Amazon, Netflix and Google/Alphabet), a trend that Huysinga sees as unsustainable.

He reports that the JPGI portfolio is currently positioned for ‘conventional good times’, with a high weighting in cyclical industrial companies such as steel producer Outokumpu, builders’ merchant Ferguson and tool supplier Stanley Black & Decker, where valuations are favourable but there is a clear path to a re-rating. However, given the risk after such a sustained bull run that the market is already pricing in the most favourable scenarios, Huysinga has reduced net gearing to near zero.

JPGI’s value-focused investment process is based on the dividend discount model (DDM) developed by J.P. Morgan Asset Management, which we describe in detail in our initiation note. Manager Jeroen Huysinga is supported by a large global team of analysts, organised by sector, who use the cash flow-based DDM valuation approach to calculate long-term expected stock returns. By assessing factors such as the quality of a company’s management and products, its competitive position and use of cash, the analysts are able to generate earnings and cash flow estimates over a range of time horizons, which they use to synthesise a projected dividend stream for each company. They then calculate a dividend discount rate (DDR) by equating the projected dividends to the current share price. The higher the DDR, the better the long-term value of the company. Between them, the c 70 analysts cover around 2,500 companies, split into 17 sectors under broad headings of financials, consumer, healthcare, industrials and TMT (technology, media and telecoms). Based on the DDR, the analysts rank the stocks in each sector into valuation quintiles, with the two cheapest quintiles forming the basis of JPGI’s investment universe.

Stocks in the cheapest two quintiles must pass a further three tests before being considered for inclusion in the JPGI portfolio. ‘Significant profit potential’ is measured as having at least 25% upside from current to normalised (based on the sector median) earnings per share. This test narrows the investment universe to c 500 stocks. The final two tests focus on catalysts for revaluation: firstly there must be an identifiable catalyst for the market to re-evaluate its view of a company, such as restructuring, new management or expansion into new markets; and secondly, the catalyst should be expected to occur broadly within the next six to 18 months. Holding periods may be much longer than this, however, as companies may still offer significant growth opportunities well after the market has begun to appreciate their potential.

Relatively few stocks can pass all four tests, and the resulting list of c 50-90 stocks forms the basis of the JPGI portfolio. The analysts monitor the whole universe, not just the two cheapest quintiles, and constantly reassess the stocks they cover, allowing Huysinga to ensure that every stock in the portfolio continues to meet all four criteria. While holdings do not have to be constituents of the MSCI AC World index benchmark, the majority are included in the index, and new positions are usually sized at 0.5-1.5pp above their benchmark weight. A number of broad limits aim to ensure the portfolio remains appropriately diversified:

At 31 December 2017, there were 79 holdings in the JPGI portfolio, towards the higher end of the typical range of 50-90 stocks. The top 10 holdings made up 22.2% of the total, a percentage unchanged on 12 months earlier, although only five names were common to the top 10 in both periods.

Within the broad overweight/underweight limits detailed above, stock selection is geographically and sector-agnostic, and is an output of where the team sees the best value opportunities. Currently this has led to appreciable overweights in financials, consumer discretionary stocks and industrials (Exhibit 3), with the biggest overweight in industrial cyclicals, where Huysinga says there are “provocative opportunities” in “great companies on good valuations”. A recent purchase in this area is US power management company Eaton, where JPGI’s manager sees the recent fortification of the management team as a clear catalyst for revaluation. In financials, Huysinga has bought insurance companies T&D (Japan) and Swiss Re, as well as adding to holdings in banks DBS (Singapore) and Svenska Handelsbanken (Sweden). The manager says banks have gone from an underweight position a year ago to one of the top five overweight sectors.

Other major purchases include Microsoft, a previous holding that had been sold on concerns over the cost of developing its cloud service Azure, but which Huysinga bought back on an undemanding valuation; Pioneer Natural Resources, a US oil exploration and production company whose low costs provide significant profit upside in a rising oil price environment; O’Reilly Auto Parts, a US automotive parts supplier whose expert customer service staff, extensive stock of products and strong distribution network should be sufficient to counter any perceived threat from Amazon; and Italian electric utility company Enel, which Huysinga says still looks cheap and is benefiting from a more shareholder-friendly style of management.

In geographical terms (Exhibit 4), most exposures are broadly similar to those of 12 months ago, with the exception of a fall in the European weighting and an increase in cash held. Gearing is currently negligible, in recognition of the strong performance of global markets, and the potential for the next significant move to be downwards. While UK exposure remains at c 13%, Huysinga says the only truly domestic UK stock he holds is housebuilder Taylor Wimpey, which should benefit from the political pressure to solve the UK’s housing crisis.

JPGI has seen particularly strong share price performance over the past 12 months (Exhibit 5, left-hand chart), with the shares moving from a discount to a premium to NAV as investors have reacted favourably to the higher distribution policy and solid record of absolute returns. As shown in the right-hand chart, JPGI has produced annualised NAV returns of c 15% over three and five years and since adopting the global focus strategy in October 2008, outperforming the benchmark MSCI AC World index over all these periods. Partly as a result of the very strong one-year performance, the share price total return is ahead of the NAV total return over all the periods shown.

NAV outperformance of the benchmark in sterling terms over all but the most recent periods shown (where it has lagged marginally by 0.5-1.5pp) has been achieved in spite of not owning index heavyweights Apple, Facebook and Amazon, which have all outperformed JPGI holding Alphabet (Google). Strong performers in the portfolio included Japanese machine tool firm DMG Mori, Hong Kong-listed Chinese insurance company Ping An Insurance, and US healthcare and health insurance stock UnitedHealth. Other healthcare stocks, including Allergan, Shire and Teva Pharmaceuticals, detracted from performance, as did US and Russian supermarket chains Kroger and Magnit, and US communications stock Dish Network, which Huysinga still favours based on the gap between the market value of the business and its strategic value as an acquisition target. All stock comparisons are in local currency terms, as JPGI predominantly hedges its currency exposure back towards the benchmark.

JPGI’s relative performance record is shown in Exhibits 6 and 7 (all in sterling terms). As well as outperforming its benchmark in share price total return terms over all but one of the periods shown, it has also outperformed the MSCI World index (which excludes emerging markets) over almost all periods, and has convincingly beaten the FTSE All-Share index, illustrating the potential benefits for UK investors of looking beyond their home market. Five-year performance versus the benchmark, as shown in Exhibit 7, has been reasonably consistent except in the first half of 2016, when JPGI’s value investment style was out of favour.

At 2 February 2018, JPGI’s shares traded at a 2.2% premium to cum-income NAV. This was a little lower than the five-year high of 3.0% reached in late December 2017, and comes after a significant and sustained re-rating since the announcement of the new distribution policy in July 2016. The current premium compares with average discounts of 0.8%, 6.0%, 6.4% and 5.8% over one, three, five and 10 years respectively. The board has been reissuing shares from treasury in response to demand and in order to manage the premium. Since adopting the new distribution policy, JPGI also reports an appreciable change in its share register, with more individual investors now owning the shares via platforms and wealth managers.

JPGI is a conventional investment trust with one class of share. At 2 February 2018, there were 126.2m ordinary shares in issue, an increase of 2.1% (2.6m) over the previous 12 months as a result of issuance since the shares moved to a premium to NAV in August 2017. The board may allot shares up to the equivalent of 10% of the share capital or repurchase up to 14.99% of shares each year to manage a discount or a premium. In January 2018, the trust announced a new issue of £30m of 30-year unsecured fixed-rate loan notes, with an annualised coupon of 2.93%. This replaces the previous £25m multi-currency revolving credit facility, and is equivalent to c 7.5% of net assets at 2 February 2018. Gearing is permitted in a range of 5% net cash to 20% geared, and at 2 February 2018, the trust had net gearing of 1.4%.

JPMorgan Funds acts as JPGI’s alternative investment fund manager (AIFM) under the AIFM Directive, and is paid an annual management fee of 0.4% of assets less current liabilities. Ongoing charges for FY17 were 0.57%, compared with 0.64% in FY16. A performance fee (15% of outperformance) may also be paid if the trust outperforms the benchmark by more than 0.5% in a financial year. The fee is paid out over four years and may be written back in the event of any underperformance. For FY17 a performance fee of £2.347m was accrued, but no performance fee was paid in respect of the year, because of underperformance in FY16.

Having previously paid dividends that broadly reflected the level of income received in a year, JPGI moved to a new, higher distribution policy with effect from the beginning of FY17. Under the new policy, which aims to give investors greater certainty of income as well as a higher yield, the trust declares a dividend of at least 4.0% of its year-end NAV, paid in equal instalments in October, January, April and July. After a transitional period in FY17 (which included a final dividend in respect of FY16 as well as three quarterly dividends), FY18 is the first year in which the policy is fully operational. In July 2017, JPGI announced a target dividend of 12.16p for the year ending 30 June 2018 (4.01% of the 30 June 2017 NAV). Because of strong NAV performance in FY17, the dividend is significantly higher than the FY17 total dividend of 6.60p. So far two instalments of 3.04p each have been declared. With net revenue per share having amounted to 3.74p in FY17, the dividend will be partly funded out of capital and revenue reserves.

Because the new policy targets a set percentage of NAV, the dividend is likely to fluctuate from year to year and may go down as well as up in absolute terms. However, the board sees the higher yield as an attractive way of satisfying investors’ desire for income without compromising on JPGI’s growth-focused investment strategy, as well as keeping the discount to a minimum. Success in this regard is evident in the fact that the trust now trades at a small premium to NAV.

JPGI has been a member of the AIC’s Global Equity Income sector since adopting its higher distribution policy in June 2016. However, it still invests principally for capital growth, setting it apart from some peers, which may follow a strategy more focused on total returns. In terms of one-year performance, the trust ranks fourth in the peer group, although the dispersion of returns is quite narrow, with six out of seven funds achieving NAV total returns of between 10.9% and 15.9%. Over three and five years and since the change to the global focus strategy in October 2008, JPGI ranks first in the group for NAV total returns. The trust has the lowest ongoing charges in the peer group, although it is one of two to charge a performance fee. JPGI trades on the smallest premium (to ex-income NAV), and has a below-average level of gearing. The dividend yield of 3.2% is a little below the weighted average, ranking fourth out of seven peers.

There are four directors on the board of JPGI, all non-executive and independent of the manager. Chairman (since 2015) Nigel Wightman was appointed to the board in 2010. Jonathan Carey, chair of the remuneration and audit & management engagement committees, became a director in 2009. Gay Collins, the senior independent director, was appointed in 2012, while Tristan Hillgarth joined the board in 2016. The directors’ professional backgrounds are in investment management and PR/communications.

Returns for New Zealand-based investors in JPGI have been enhanced by weakness in the NZ dollar versus sterling in recent months. While medium-term annual returns (three and five years) are similar for both UK and NZ investors at c 12-18% pa, NZ investors have seen 25.3% and 33.0% NAV and share price total returns over 12 months to 31 January 2018, compared with 11.9% and 19.5% for sterling-based investors. With the majority of the strengthening in sterling taking place between September and December, NZ investors have also seen more positive returns over three and particularly six months, although returns over one month have been flat to negative. Longer term, sterling has been weaker on average versus the NZD, depressing returns for NZ investors.