Paul Locke                                               Investment      ...
2GLOBAL SNAPSHOT                                                      Yield dynamics – 10Y yield and % point changeStrateg...
3                                       KEY THEMES                                       MACRO                         All...
4                                      response. Similarly, despite spending billions of dollars on welfare projects in an...
5                                     monetary stability and minimise risks of a banking crisis. This may actually prove m...
6Figure 1: Scenario analysis    Scenario                                  Key fund exposure                   Focus/dynami...
7                                    successor over his two older brothers, together with the young General’s (as he has b...
8                   Event specific    Events such as the Queen’s Diamond Jubilee (June) and the London Olympics (July-    ...
9                                                                                                                         ...
10                                          Cynics may argue that this is merely a continued base effect from the post-Leh...
11                                     OVERVIEW                                     •   Yield – not all income is equal   ...
12                                       YIELD - ALL INCOME IS NOT NECESSARILY EQUAL                                      ...
13                                    levels). In these cases, market pricing finally began differentiating between not ju...
14Figure 6: Selected income-focused trusts – yield relative to UK inflationSource: Canaccord Genuity Limited, Datastream  ...
15                                       and this should be taken on board. However, Canaccord analysis using an annualise...
16                                    Funds came and went in 2011.                                    Notable casualties i...
2012 forward review - Opportunities & Risks
2012 forward review - Opportunities & Risks
2012 forward review - Opportunities & Risks
2012 forward review - Opportunities & Risks
2012 forward review - Opportunities & Risks
2012 forward review - Opportunities & Risks
2012 forward review - Opportunities & Risks
2012 forward review - Opportunities & Risks
2012 forward review - Opportunities & Risks
2012 forward review - Opportunities & Risks
2012 forward review - Opportunities & Risks
2012 forward review - Opportunities & Risks
2012 forward review - Opportunities & Risks
2012 forward review - Opportunities & Risks
2012 forward review - Opportunities & Risks
2012 forward review - Opportunities & Risks
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2012 forward review - Opportunities & Risks

  1. 1. Paul Locke Investment 2012 – opportunities and risks This is our fourth consecutive annual trust review and it comes after one of the most tumultuous years for the global economy and the pricing of risk assets in a generation. It would be a delight for us to argue the case for a strong rebound in both global growthInside levels and equity pricing in 2012, but the reality is that, for the west at least,Global snapshot .................................2 structurally, little has changed thus far.Key themes.........................................3Investment trusts ...............................9 In last year’s review we highlighted three key questions for investors:Overview .......................................... 11 • Can the Euro survive its design flaws?Portfolio strategy ............................. 20Other stock picks for 2012............. 24 • What will the level of US commitment be to fiscal orthodoxy (and when)?Summary.......................................... 28 • What are the prospects for a soft landing in China?Key data trends for 2011 ............... 29 These questions remain unanswered, which suggests to us continued strong volatility, uncertainty and risk in the coming year. Political incompetence and vacillation has left the global economy floundering, with the risk of renewed recession (or worse) and we think this could continue in 2012 as the US heads further into its election cycle. We have moved from a financial to a sovereign debt crisis and almost back again with a series of band-aid (monetary) policies failing to provide a proper resolution to the key problem of excessive debt and the need for governments and individuals to deleverage. Companies have impressed in taking up the slack against a poor economic backdrop and, in many cases, remain lean and profitable. But, questions remain over forward earnings as Europe in particular heads back into recession. Despite politicians’ inability to grasp the economic nettle, we see grounds for optimism, though this remains on a highly selective asset class and manager-specific basis. We hope to point out some of these potential “winners” and areas to avoid in 2012 and beyond in the following pages. We believe the year ahead offers a number of changes and challenges, not all of which will be negative. It will be a demanding time for trusts, their managers and boards as market uncertainties continue but also as we move towards the introduction of the Retail Distribution Review (RDR) at the year-end. Investors will need to be nimble and selective to profit from the current market environment, but we are of the view that the broader closed-end fund sector remains the best place to generate excess returns.This research note is produced by Canaccord Genuity Limited which is authorized and regulated by the Financial Services Authority (FSA).This is non-independent research and a marketing communication under the FSA Conduct of Business rules. Please see the important disclosures section inthe appendix of this note which are an integral part of it or visit for moreinformation.11 January 2012 2012-004
  2. 2. 2GLOBAL SNAPSHOT Yield dynamics – 10Y yield and % point changeStrategy drivers for 2012• Macro concerns continue to dominate – another difficult year.• Possible collapse or (at minimum) transformation of the Euro – more European QE likely.• Equities – a mixed picture: - Emerging markets start to outperform developed markets from H2. - Low interest rates will continue to reward income – but not all yields are alike. - Markets are not normalised – key thematic drivers and herd mentality will drive profits.• Commodities – risks and opportunities abound, but Key market trends - 2011 drivers will be stock and sector specific: - Risks of a Chinese hard-landing imply continued, sentiment-driven volatility. - Significant opportunities in constrained supply assets (gold, shale gas). - Oil market volatility to intensify – supply not constrained, but political risks are rising (particularly over Iran).• Property – prime assets to continue to drive NAV growth.• Defensive assets will maintain their advantage.• Growing risk of global socio and geo-political unrest – disenfranchised populations carry risk and where next after the Arab spring? Inflation (Current annual rate - %)• Extended recession in the West and risks of rising global protectionism.• Emerging market – monetary easing provides some (but not sufficient) support to global markets.• 2012 pricing suggests an even stronger reliance on QE and corporate earnings to underpin equity growth.Notable elections in 2012January Egypt & TaiwanFebruary Greece & YemenMarch Egypt & Russia (both presidential). IranApril Korea, France (presidential 1st round)May Palestine, France (presidential 2nd round) Budget deficits (% of GDP)June Bahamas, Serbia, FranceJuly Mexico, MaliAugustSeptember Hong Kong Venezuela & Slovenia (both presidential). Ukraine,October Georgia and LithuaniaNovember US & RomaniaDecember Korea (presidential) Source for all charts: Canaccord Genuity Limited, Datastream2012 – opportunities and risks 11 January 2012
  3. 3. 3 KEY THEMES MACRO All aboard If investors thought 2011 was a rollercoaster ride, 2012 risks shaping up to be even more unpredictable. For four years, we have argued that the crisis of the west has been structural in nature rather than cyclical and, therefore, something that can be resolved by a resumption of growth. Many, if not most, structural issues (excess debt and the need for individuals and governments to deleverage) remain fundamentally unresolved, while new distortions in lending, debt and broader financial markets have been created (notably state ownership of its own asset base in the West through newly printed money). Dealing with change A key concept for investors to accept is that the world has changed and continues to change. The crisis of 2008 accelerated this process and we believe the eventual winners could be many of the larger emerging states such as Brazil, India and China. However, this is not guaranteed and these states, along with Russia, the fourth member of the BRIC quartet, have their own problems to overcome in 2012. Therefore, we do not expect a repeat of post-Lehman’s 2008 when China expanded its own balance sheet to support the global economy this time around (or at least not to the same extent). As we have argued previously, however, there is always room for pricing growth in a variety of asset classes. Part of this could be general, supported by still more monetary expansion as the US, Europe and the UK deploy yet more quantitative easing (despite the largely still unproven case for its use thus far). But more likely, in our view, is that investors will have to delve deeper to unearth the pricing gems in 2012, amid a backdrop of sluggish economic growth, heightened fears for corporate earnings and, ultimately, the still strong risk of sovereign and bank sector default. KEY EVENT RISK Below we explore some areas that we see as the key geopolitical and economic risks moving into 2012 and, more crucially, how some anticipated events could be used through exposure to specific funds. Instability in the Middle East Key event risks in 2012 could centre on a number of different but inter-linked points in the Middle East. Public aspirations from the Arab spring of 2011 remain, as yet, almost entirely unsatisfied and further violence should be expected. Where political pluralism of some kind has taken hold, the clear winners have been Islamic-focussed organisations, which is likely to raise concerns in the west, so long the supporter of a number of the region’s autocratic regimes. But the Arab spring has now spread to one of the region’s lynchpin states in Syria and the collapse of the Assad regime carries risks far beyond Syria’s borders, with a likely impact on Iran, Lebanon, Turkey and Israel. Elsewhere, an increasingly fractured Iraq is more and more coming under Iran’s influence (a final humiliation in wake of the Iraq war), while prospects for a strategic military strike against Iran also remain. This may or may not be linked to that country’s nuclear ambitions, or to a growing power struggle from within the Middle East itself. Syria’s collapse could ultimately provide for growing internal divisions within Iran (a second Green revolution, perhaps) while pressures for an oil embargo to be imposed on Iran could spark a more aggressive11 January 2012 2012 – opportunities and risks
  4. 4. 4 response. Similarly, despite spending billions of dollars on welfare projects in an attempt to placate its own population, discontent within the Shia minority in Saudi Arabia remains and may surface further in 2012. This all has implications for the oil sector. While OPEC has the capacity to raise output (and could have done so already as the most vivid sign of its support for the global economy), an event-driven spike in oil prices, with all its implications for economic well being, cannot be dismissed in 2012. Hard landing in China However, this appears unlikely to us, particularly with the transition in power of much of the political establishment that is due to take place in early 2013. But investors should be prepared for such an eventuality, which could spark (at least in the short term) a potential collapse in commodity pricing, with implications for a vast number of states including the producer states in Latin America as well as Australia and Canada. Once more, we highlight that while attention in recent years has been focussed on Chinese demand as the key underpin for commodities pricing, this ignores fundamental supply factors and any notable correction in pricing should be viewed opportunistically. Chinese authorities have room to ease monetary policy further, though not to the same extent as in 2008. However, we expect the government will, above all else, be keen to oversee a smooth transition to the new political leadership that takes control in 2013, which suggests it will do everything possible to avert any economic hard landing. China – a changing of the guard One of the key changes for 2012 will be the run up to an effective changing of the old guard in China – this after a decade in power. Amid a backdrop of growing structural weakness and imbalance in the Chinese economy, the country is due to replace much of its political leadership in late-2012, for just the fifth time since the revolution and with its new leaders set to rule for the next decade. The Communist Party has already indicated a dramatic shift away from what some say is a failing system of firstly export-led growth and subsequently investment-led expansion. As well as Vice-President Xi Jinping and Vice-Premier Li Keqiang being likely to succeed the current incumbents, President Hu Jintao and PM Wen Jibao effective from the Congress of late-2012 (officially from March 2013), there are due to be significant changes to the higher ranks of the People’s Liberation Army (PLA) as a number of its leading figures reach mandatory retirement. Orderly transition will be the priority, which will include doing everything to ensure continuity in economic well-being for the populace. However, this political accession will also be accompanied by strong economic transition from 2013 onwards and particularly in 2013-15 (external situation allowing) as attempts are made to refocus towards a more consumption-based growth strategy. This will not be easy and perhaps key here will be how the new government reacts to any signs of civil unrest. Sovereign default Arguably, the key western developed states have escaped lightly thus far. With global interest rates low and the emphasis firmly on creative book keeping, debt burdens have been manageable. However, 2013-15 offers one of the largest roll-over periods in history for a number of western economies. With this backdrop, one has to ask whether these highly developed but indebted states could cope with another banking or liquidity crisis. The answer has to be no, but even in the absence of such a crisis, sovereigns face a wall of repayment, excessive debts and a likely increase in financing costs as interest rates eventually rise (or new debt terms are secured). The European authorities have already pushed forward vast sums in the form of a new borrowing facility in a bid to ensure2012 – opportunities and risks 11 January 2012
  5. 5. 5 monetary stability and minimise risks of a banking crisis. This may actually prove more beneficial, given its specific targeting, than the broad-brush QE approach adopted elsewhere. However, we cannot dismiss the risk of sovereign default and a renewed banking crisis in 2012.Prospects for the other BRICs (and Time has already been called by some on the BRIC phenomenon. However, while we emerging markets) agree that the BRICs face significant problems in H1/12, they again have room to ease monetary policy as the global economy slows. Indian inflation appears increasingly structurally ingrained, which raises concerns, while Russian autocracy looks likely to come under ever greater scrutiny. However, broader trends such as young populations (ex-China where demographic problems will grow), ever expanding credit, mortgage and consumer markets and the sheer dynamics of many emerging market companies appear likely to continue to underpin the BRIC and broader emerging market phenomenon for some time. US elections The US elections will perhaps be the defining event of 2012, as well as just how well the US and global economies cope. Key will be the ability of political figures to rise above the mud-slinging and enact necessary fiscal reforms (or even extend or manage existing legislation). Signs are not positive that this can be achieved, though we see no reasons to be excessively pessimistic at this stage. Much will depend ultimately on the choice of Republican candidate to face President Obama which, as yet, is undecided. Any polarisation of politics does not bode particularly well for strong and decisive legislative action with prospects for either damaging tax cuts on one hand or a failure to rein in spending excess on the other.11 January 2012 2012 – opportunities and risks
  6. 6. 6Figure 1: Scenario analysis Scenario Key fund exposure Focus/dynamic Capital protection Personal Assets Trust; Premia Personal Assets may not suit all investors with concerns over two Plus key portfolio dynamics – US Treasuries and Gold (some 50% of NAV). Premia Plus will succeed IVPH.L from end-February 2011 and offers a proven methodology through a futures-based allocation model and will provide an original concept for investors in 2012. Chinese hard landing All commodity funds will be hard hit, but indirect exposure will go significantly further. Chinese centred funds and those exposed to producer nations in, for example, Brazil, Australia and Canada could be expected to suffer disproportionately Commodities City Natural Resources High Yield Potential for a shock and continued escalated volatility on Chinese hard landing prospects. Yet key themes such as shale gas/oil and margin growth at gold miners continue to underpin this fund relative to its peers, while M&A activity is also expected to be supportive Cyclical recovery – emerging markets Templeton Emerging Markets. We still advise caution on many emerging market equities in Q1- Q2, but monetary policies are now being eased and the long- term case for the asset class and particular high profile states remains fundamentally intact. Key emerging markets will be the long-term winners of the West’s current crisis. Discount to cash Federated Enhanced Treasury See page 27 Income Fund (FTT.N) Discounted yield Guggenheim Enhanced Equity A covered call fund, GGE strongly outperformed the S&P500 in Strategy (GGE.N) 2011 and more than doubled its yield (to an indicated 7.7%, with 3% from income). Yet this elevated distribution policy has yet to be fully reflected in its discounted rating (-14.5%). Europe Jupiter European Opportunities Positive stock and country allocation with strong management. Inflation protection Western Asset/Claymore Inflation- While UK-listed funds offering “inflation protection” attract linked Opps (WIW.N); Western significant premiums (such as those in the PFI arena), WIW and Asset/Claymore Inflation-linked WIA both attract double-digit discounts, offer yields of circa 4% Secs (WIA.N) and are at least 80% invested in inflation-linked securities and has strongly outperformed the S&P500 in the last 5 years. Innovation & development Biotech Growth Trust A vibrant performer in its own right, BIOG also benefits from accelerated bid activity in the sector, including that for key holding Pharmasset. With cash-rich pharma stocks seeking to buy rather than develop new product lines, we see the potential for further growth in the BIOG NAV. Japan Baillie Gifford Japan Stronger GDP growth prospects as the post-earthquake recovery continues, combined with exceptional stock selection from manager Sarah Whitley. Oil price spike Artemis Alpha; Petroleum & Over one-third of the ATS portfolio is exposed to oil and gas Resources Corp (PEO.N) producers with, markets allowing, still strong upside value to be gained from the present carrying value. PEO’s NAV effectively tracks the DJ Oil & Gas Index and offers a portfolio dominated by names such as Exxon Mobile and Chevron. Property F&C Commercial Property Trust; Continued exposure to prime assets is recommended, at least in ISIS Property Trust H1/12. Strong and proven managers at F&C REIT, with IPT also commanding a significantly higher yield than the sector average. Yield differentiation New City High Yield; Middlefield Proven manager with an exceptional track record in active Canadian Income portfolio management, NCYF offers both a more durable and differentiated source of yield (for MCT see page 24).Source: Canaccord Genuity Limited The death of North Korean leader Kim Jong-il in December 2011 threw another potential Korean peninsular – death of a ‘hand grenade’ into the global mix. Jong-il’s death and his succession by his third son, dictator Kim Jong-un, raises the prospect of heightened political uncertainty, both internally and regionally. Succession planning in North Korea has been underway since Kim Jong-il suffered a stroke in late-2008. However, the late nature of Jong-un’s move to become the preferred2012 – opportunities and risks 11 January 2012
  7. 7. 7 successor over his two older brothers, together with the young General’s (as he has been termed) lack of experience, suggests his powerbase is likely to be immature and underdeveloped. This latest succession, therefore, suggests an expanded role for the military, at least in the short term. External powers are also likely to seek to raise their influence in coming months, particularly China. However, prospects for a Korean version of the Arab spring seem small in such an isolated state and, more likely, is a scenario of rising regional tensions in the broader Korean peninsular. A shift towards protectionism Perhaps one of the greatest triumphs of 2011 was the lack of protectionism or new trade barriers that are often erected opportunistically during a period of global economic crisis by politicians threatened by their own inadequacies to cope with that crisis. This does not mean they will not come, however, and an extended period of stagnation or renewed recession in the west would dramatically increase the likelihood of an escalation in trade tensions and the imposition of punitive sanctions by certain states. ON A BRIGHTER NOTE … The most favourable scenarios for 2012 generally point to a further year of muddling through for the global economy with the possibility (though not probability) of a surprise on the upside for global growth given that sentiment is so weak. Investors may also benefit from a herd mentality in following the continued risk-on, risk-off movements and close correlations of major asset classes in Q1 in particular. But, we recommend being quick to take profits on both sectors and outperforming stocks. In terms of governmental support, key will be to watch for further supportive action from the world’s monetary authorities, which equity markets have generally lapped up during the last two years. However, the risk here is that the drug of monetary stimulus will begin to wear off and the resultant equity highs will be less frequent and less euphoric. Corporate earnings We think this may be the biggest determinant of equity movements in 2012 – just how well earnings growth performs both in absolute terms and relative to expectations. Apart from governments’ continued support of risk assets through monetary expansion, it has been the broad health of company balance sheets that has maintained equity expansion in recent years. While we expect this to continue in a number of areas (defensives, gold producers, emerging market consumption plays, innovative technologies), strong focus should be paid to first quarter earnings in particular and to the durability of income streams in order to determine just how well companies are performing, this as Europe and, possibly thereafter, the US head back into flat growth or outright recession. H2 revival in emerging markets Many emerging markets are now at the top of their previous tightening cycle and some, including China and Brazil, have already been cutting interest rates as their economies slow. Inflation remains relatively entrenched in states such as India and Turkey (the latter offering the risk of another hard landing) and we advise caution. However, expectations are that a renewed loosening of policy during 2012 will provide support to equities. The underperformance of emerging market equities in 2011 was perhaps not surprising given their strong recovery since the post-Lehman’s era. However, we regard the asset class strongly from both a top-down and bottom-up perspective, with an emphasis firmly on managers with a bias towards stock selection rather than index replication.11 January 2012 2012 – opportunities and risks
  8. 8. 8 Event specific Events such as the Queen’s Diamond Jubilee (June) and the London Olympics (July- August) should not be entirely dismissed and they offer potential upside to UK-focussed equities and other asset classes in 2012. Specific analysis of the benefits of major events on stock markets is relatively limited and, of course, gains have already been derived by London and the broader UK during the construction and build-out process. However, we think additional tourism and consumption are likely to benefit key stocks in 2012. … AND MICRO We see two defining risks in the year ahead – the risk that corporate fundamentals, having been so strong in recent years, could disappoint as economies weaken once more and, secondly, the imposition of ever more restrictive regulation. Of course, the idea of tighter regulation in, for example, the banking sector, is to create aExcessive regulation carries risks more efficient and secure system. However, risks remain that inadequate steps will merely delay not prevent a renewed banking crisis, while excessively restrictive and hurried laws could prompt both a further decline in lending and, as we have already seen, threats by major institutions to relocate. But not all legislation is negative. After all, 31 December 2012 will see theBut RDR provides the Trust world implementation of the FSA’s Retail Distribution Review (RDR), initially launched in 2006 with opportunities as a means of improving training of financial advisers and raising the transparency and fairness in the fee charging system. 2012 could, therefore, be a pivotal year for the entire investment trust sector. Will trusts themselves be sufficiently well prepared to access the distribution platforms? Which funds or groups will benefit most? And, will independent advisors be sufficiently well versed in the often esoteric workings of the trust sector?2012 – opportunities and risks 11 January 2012
  9. 9. 9 INVESTMENT TRUSTS TRENDS IN PRICING … At the end of 2011, the average, cap-weighted discount for the trust sector had barely changed over that for the corresponding period of 2010, reaching 10.9% against 10.5% for end-2010. However, this masked significant changes in the ratings applied to both specific sub-sectors and, of course, individual funds. Yield continues to dominate The search for yield remained a dominant feature with income funds often rewarded pricing with elevated ratings. Risk perception also prompted a notable de-rating of certain asset classes, including property and private equity. This slippage in discounts was often accompanied by little regard for some strong individual performances and increasingly active attempts by at least some of these funds to buttress shareholder value. Such diverse trends in pricing were exacerbated by the August 2011 sell-off in equities. Many sectors experienced widening discounts in this period, with the exception of areas such as UK Income Growth sheltered by a stronger retail shareholder base and the allure offered by a headline yield. Figure 2: Sector discount/12-month NAV performance trends (end-2011) 35.0 0.0 25.0 -10.0 15.0 5.0 -20.0 -5.0 -30.0 -15.0 -40.0 -25.0 Discount (LHS) 12 mth NAV perf (RHS) -50.0 -35.0 Technology/Media Sector Specialist: Property Sector Specialist: Property Private Equity - Fund of Funds Sector Specialist: Property Asia Pacific ex Japan - Income Global - Growth & Income UK - Income Growth Global/Overseas Growth UK - Growth UK - Mid Cap UK - High Income Biotechnology/Pharmaceuticals Emerging Markets - India Asia Pacific - inc Japan Private Equity - Direct Global - Fund of Funds Japan - Smaller Company Emerging Markets - China UK - Small Cap Asia Pacific ex Japan - Smaller Asia Pacific ex Japan - General Sector Specialist: US - General Sector Specialist: Commodities Japan - General Europe - General Europe - Smaller Companies US - Smaller Companies Weighted Average Emerging Markets - Global Sector Specialist: Environmental (Direct - Europe) & Natural Resources (Direct - UK) Sector Specialist: (Equity) Companies Source: Canaccord Genuity Limited, Datastream. Note: past performance does not predict future results … AND PERFORMANCE Some performance goes Canaccord’s NAV performance analysis of major funds in 2011 throws up a number of unrewarded interesting trends. First is the sharp outperformance of private equity as an asset class, with private equity trusts comprising nine of the top ten performing trusts during the year.11 January 2012 2012 – opportunities and risks
  10. 10. 10 Cynics may argue that this is merely a continued base effect from the post-Lehman’s low or that valuations and pricing, in line with global equity markets, are at risk of coming off once more, making 2011’s performance illusory and temporary. Canaccord would strongly disagree. The sector has moved on. Specific funds such as Princess, Dunedin Enterprise and, more recently, SVG Capital, have announced shareholder-friendly actions including the return of capital to investors. Others such as F&C Private Equity (FPEO) have continued to pursue a relatively uninterrupted programme of enhanced value realisations despite a still weak economic and market backdrop. While risks do remain, particularly regarding the valuations of specific portfolios, it is our view that those with conservative pricing models such as FPEO actually offer shareholders a relatively high level of downside protection, particularly at current levels of discount.Figure 3: Key investment trusts Top 10 performers by NAV (TR) Bottom 10 performers by NAV (TR)Source: Datastream, Canaccord Genuity Limited.Note: this excludes a number of smaller UK-listed vehicles. Past performance does not predict future resultsA temporary slip in performance? Sectors that dominated the underperformers in 2011 were the emerging market and commodity funds. Once more, this phase of underperformance should be put in context of the previous sharp rise in values in the preceding 2-3 years. Indeed, the weighted average NAV decline of 17.1% for the emerging market trusts in 2011 means the three- year growth rate was reduced to a still robust 83.8%. Similarly, taken over the last decade and even allowing for the slump in 2008, the MSCI Emerging Market Index still rose by 265% in the decade to end-2011, an almost eight-fold increase on that for the S&P500. Other key underperformers in 2001 included SR Europe and Aurora, though these reflected a far higher degree of fund-specific and stock selection weakness rather than soft markets alone. Biotech stars in NAV terms By sector, the leading performer in NAV terms in 2011 was the small Biotech/Pharma sector, with the private equity fund of funds and property sectors not far behind. At the other end of the scale, the largest losses occurred in the Indian and Chinese fund sectors, with drops of over 30% in NAV over the year.2012 – opportunities and risks 11 January 2012
  11. 11. 11 OVERVIEW • Yield – not all income is equal • Board-led activity – not a great start • Alliance Trust – a year of change • RDR – hard work ahead to maximise benefits Highlights of the year ahead In this year’s review, we highlight a number of themes that we regard as appropriate, both historically and looking forward into 2012. The world can look forward to a number of key events in 2012 including the 18 National Congress of the Communist Party of th China, and the subsequent transition of power within the ruling elite for the first time in a decade. We also have the US Presidential and legislative elections, the London Olympics, the Queen’s Diamond Jubilee and, in the trust world, the final push to financial equilibrium as RDR comes into effect from the start of 2013. In last year’s review, we highlighted the persistence in underperformance across elements of the trust sector, arguing in favour of greater elasticity in the movement of funds between management groups for perpetually underperforming managers and that Lacking imagination? the “solution to such persistence in underperformance must lie with boards, managers and, of course, shareholders”. We also argued that Discount Control Mechanisms (DCMs), while useful as part of a wider armoury will not resolve issues such as relentless weakness in relative NAV performance and that boards must become more imaginative in the way they approach change in order to protect and enhance value for the shareholders they represent. This year, we continue this theme in part with one of the Global Growth sector’s weakest performers of the last five years, Alliance Trust (ATST.L), which in 2011 initiated its first, democratically accessible DCM. We ask whether this actively applied DCM has added value for shareholders and whether we can expect more of the same in 2012. Yield dynamics – how well do We also look into the effects of dividends on a fund’s profile. Yield has come to dominate trusts stack up? discount pricing in an era of exceptionally low interest rates. But this raises as many questions as it answers. For example, while many trusts amplify the impact of a consistently rising nominal dividend, often over many decades, just how many funds are fully maintaining the value of these dividends against a backdrop of often significant inflationary pressures?11 January 2012 2012 – opportunities and risks
  12. 12. 12 YIELD - ALL INCOME IS NOT NECESSARILY EQUAL If there has been one dominant, even overriding, theme in the trust world in recent years,Interest rates to stay low for some it has been that of income. This is not surprising in an environment of both heightened time yet uncertainty and historically low interest rates, with both the US Federal Reserve and the Bank of England having already signalled their intent to keep rates low for the next two years. Almost all fund launches and secondary market issues in 2011 had a strong income theme, while ratings of higher-yielding trusts also remained relatively high and seemingly protected. However, a high headline yield does not necessarily translate into a good deal for investors. Indeed, shareholders will have to be increasingly savvy in the year ahead to ensure their dividend flow is not disrupted (at the stock or sector-specific level) or that the benefits of this yield are not offset by a variety of other factors. Three- year figures look good … In this report we seek to analyse some of the attributes offered by higher yielding funds in recent years to determine if elevated pricing has, in effect, been worthwhile. As shown in the graphic below, on a three-year basis many high-yielding funds have delivered exceptional NAV returns, far beyond those offered by government debt. And many of these funds have been rewarded for these profiles, with elevated, often premium, ratings. Figure 4: Selected funds - yield relative to NAV total return (three years) Source: Funddata, Canaccord Genuity Limited However, over 12 months the picture looks different, with many funds that often retained… but shorter-term dynamics raise elevated ratings delivering a poor showing in terms of overall NAV returns. Yet this questions disparity in return profile was not always reflected in weaker pricing levels, with the glamour of a high headline yield often underpinning prices despite evident weakness and, in some cases, often strong losses on the capital side. This has begun to change, however, with heightened market volatility in the final quarter of 2011 prompting de-ratings on high-yielding funds such as TR Property Trust (TRY.L). We also saw other, even premium-rated yield plays such as Henderson Far East Income (HFEL) and Blackrock Commodities Income (BRCI.L) move back into discount territory (albeit at marginal2012 – opportunities and risks 11 January 2012
  13. 13. 13 levels). In these cases, market pricing finally began differentiating between not just a high headline yield, but the broader dynamics of an often poor total return profile offered by at least some of these funds. Figure 5: Selected funds - yield relative to NAV total return (12 months) Source: Funddata, Canaccord Genuity Limited One further dynamic that we believe investors should increasingly take on board is the And what about inflation? current and future rate of inflation, as rising prices necessarily eat into or erode the value of a fund’s dividend income, particularly if growth in this income is not fully maintained. This is particularly pertinent going forward as central banks seem keen to foster even higher price pressures in order to monetise debt. Indeed, the priority is on loose and even highly expansionary monetary policy to support growth (almost at any cost) with pricing pressures that do exist (now and in future) of secondary concern to many governments. So where do the yields of many of our income-based funds feature relative to current levels of inflation? As can be seen in the chart below, many UK-listed funds fare poorly. Indeed, not only have many incurred capital losses over the last year, they also feature a headline yield that is below the current rate of UK inflation, offering, therefore, far more than investors would be able to generate from keeping their money in the bank, but a real terms contraction nonetheless. If UK inflation were to persist at these levels, therefore, it is not just the headline yield that is important, but the real terms adjusted level of payment and, of course, the rate of forward growth likely to be achieved in a given fund’s future dividend stream.11 January 2012 2012 – opportunities and risks
  14. 14. 14Figure 6: Selected income-focused trusts – yield relative to UK inflationSource: Canaccord Genuity Limited, Datastream Yield growth – the real dynamic? Dividend growth disappoints Much is often made in the trust sector of funds having delivered dividend growth for extended periods, often stretching into many decades. Significantly less emphasis is placed on the actual rate of dividend growth that has been delivered during these years. However, surely a real test of Distribution of yield growth by fund (5 year, % of total) the vibrancy of a manager’s performance is the willingness to share those benefits with the fund’s shareholders, through both Alpha delivery and dividend growth. But dividend expansion within the trust sector over the last five years has been Source: Funddata, Canaccord Genuity Limited disappointing to say the least. There are, of course, exceptions, with funds such as City Natural Resources High Yield (CYN.L,) having delivered a doubling of its dividend in the last five years, only to see its headline yield diluted by the even more dynamic rise in the share price and NAV.Inflation-adjusted dividend growth But we find the overall picture disappointing in terms of the ability of many funds to is even weaker expand their payout ratios at a decent rate over time. Now, of course, many of these funds do not even claim to have a progressive dividend policy: they are growth-orientated2012 – opportunities and risks 11 January 2012
  15. 15. 15 and this should be taken on board. However, Canaccord analysis using an annualised rate of dividend growth for the last five years for 435 London-listed trusts reveals that a staggered 71.7% had either failed to implement any annualised increase over this five- year period or had actually experienced a contraction in their dividend payments (perhaps temporary, but a cut nonetheless). Only 28.3%, or less than one-third of trusts, experienced an annualised growth rate in their dividend over this extended five-year period under review. Yet while this may be Inflation adjusted yield growth (5 year, % of funds) disappointing in its own right, a pure expansion or contraction in dividend growth rates does not tell the entire story. Over this five-year period, inflation in the UK averaged an annualised 3.23% or a cumulative 17.2%. Now this, to the shareholder at Source: Funddata, Canaccord Genuity Limited. least, should represent a natural level of dividend growth required for the level of their income to stand still. However, when adjusted on this basis, the percentage of funds that have delivered sub-inflation growth in their five- year annualised dividend rate rose to 78.6%, with only 21.4% of LSE listed trusts managing to grow their dividend at a level in excess of the cumulative rate of UK inflation in this period.Closer scrutiny of yield dynamics is In summary, we suggest that rather than looking at the headline yield, investors need to needed delve far deeper, looking at the level and consistency of capital growth achieved by a particular manager (as this is highly complementary to any dividend payment) and the rate of growth in dividend that has and is expected to be obtained from a particular fund. BOARD-LED ACTIVITY - NOT A GREAT START How active were boards in 2011? In our 2011 forward review, we argued that persistence in NAV underperformance had become endemic in some areas of the trust sector and that Discount Control Mechanisms (DCMs) had, in some respects, simply perpetuated such underperformance. We also stated that we believed the sector lacked the “elasticity in movement” and that the answer “cannot be with yet more buybacks or tenders and removing capital from the Trust market. The answer has to be with board and investors becoming more proactive in moving assets elsewhere”. Not very is the answer! Did this prove to be the case in 2011? The short answer has to be no. We did not see any dramatic upsurge in boards seeking to move assets from perpetual underperformers to higher Alpha managers or from overpopulated sectors to areas that are vastly under- represented (such as mainstream US equities).11 January 2012 2012 – opportunities and risks
  16. 16. 16 Funds came and went in 2011. Notable casualties included Anglo & Selected trust sectors by capitalisation Overseas plc and Electric & General (£m) Investment Trust, though assets were not retained within the trust sector by initiating something new or innovative – a move to an asset class or manager that investors wanted and would perhaps appreciate more (and price accordingly). Separately, 2011 saw one trust move away entirely from its previously tight DCM. Gartmore European (now Henderson Source: AIC European Focus Trust) having seen its capitalisation slip from over £400 million to under £90 million, changed tack on its DCM, investment remit and approach – this to effectively prevent a further death of a thousand cuts. While the board of Gartmore European decided to abandon a rigid system to prevent the fund moving to an illiquid rump, contrast this with Alliance Trust – which moved from perennially denying the use of buybacks to become one of its greatest advocates, at least during 2011.STS board deserves all the praise We would argue that the most rewarding, board-led move in the trust sector in 2011 was that of Securities Trust of Discount trends, STS versus 12-month average Scotland (STS.L). The fund 6 had long struggled in the UK 4 Income Growth sector with a 2 comparatively low level of 0 reserves and a surplus of -2 peers, with the board -4 -6 therefore making the decision -8 to move the fund to the Global -10 Growth & Income sector. A 09/02/2011 09/04/2011 09/05/2011 09/06/2011 09/08/2011 09/09/2011 09/11/2011 09/12/2011 09/12/2010 09/01/2011 09/03/2011 09/07/2011 09/10/2011 simultaneous change in fund manager (while staying at STS Ave Martin Currie) provided a Source: Canaccord Genuity Limited, Datastream further fillip, with the move welcomed by the market with a shift to a premium rating. STS has since this period sustained a good initial performance in its new home, outperforming many of its counterparts, albeit over a very short time. A new style of product from Other changes were also apparent. Invista Foundation Property Trust has moved to the Invesco stewardship of Schroders, while perhaps more exciting is the change in Invesco Perpetual Select’s Hedge Fund class to that of a conceptually new (for the trust sector), long-only model operated by the group’s Premia Plus team in Atlanta. Canaccord met with this team in late-2011 and we believe it offers a differentiated model from the Fund of Hedge Funds grouping, with a strong record in terms of minimising drawdowns (thereby enhancing overall returns) and this against a backdrop of full asset liquidity and no costly2012 – opportunities and risks 11 January 2012