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F&C Managed Portfolio beats benchmark despite widening discounts

F&C Managed Portfolio reports that, for the company’s financial year to 31 May 2016, the NAV total return (i.e. adding dividends paid to capital performance) was -4.8% for the Income shares and -4.5% for the Growth shares which represented outperformance against the -6.3% total return for the FTSE All-Share Index, the benchmark index for both Portfolios. The Investment Company sector, as measured by the FTSE Equity Investment Instruments Index, returned -2.5%. For the year ended 31 May 2016, four interim dividends have now been paid totalling 5.2p per Income share (5.0p for the previous year). In the absence of unforeseen circumstances, your Board intends again to declare three interim dividends, each of not less than 1.2p per Income share payable in October 2016, January 2017 and April 2017. A fourth interim dividend will be paid in July 2017 when a clearer view emerges of income for the year.

Peter Hewitt’s manager’s report says a key factor behind the performance is illustrated by looking at the average discount across investment companies in the sector (excluding private equity, property, hedge funds, debt and leasing funds and infrastructure). This looks at investment companies, which are mainly invested in equities and from this it can be seen, that for the first part of the year discounts were relatively stable and then in the second half, they widened from around 5.5% to nearly 7% by the end of the financial year. There was a noticeable widening of discounts around the time the Federal Reserve raised US interest rates in December and again in January/February when real concerns over prospects for global growth became apparent. However as these concerns appeared to ease there was a partial recovery towards the end of the period.

Both portfolios were affected by this trend. He says it is best illustrated by the average discount movements amongst certain sub-sectors of the investment company universe over the second half of the financial year. For example, Technology trusts experienced a 7% widening, for European trusts it was 3%, whilst for UK Smaller Companies and UK All Companies, it was 2.4%. Even UK Equity Income experienced on average a 1.3% widening out of the average discount between the share price and the net asset value. Discounts in investment companies have often been indicators of risk and so the evidence above of discount widening could be viewed as an indicator of rising risks to the global economy and also the risk of Brexit will have been a factor. This trend will impact equity related sectors most, however it is trusts in these sectors that will be the principal generator of long term performance and so, unless a serious downturn is likely, should continue to form a core part of both portfolios.

He believes that, historically, there has been a perception that when equity markets rise the investment company sector, due to its gearing and also a narrowing of discounts, tended to outperform. Similarly when the reverse occurred the sector tended to lag mainstream equity indices. Other factors such as the level of sterling also have an influence however in broad terms these were principal drivers to relative performance of the investment company sector.

Due principally to substantial levels of new issuance, the exposure of the sector to equity markets has changed over the last decade. During that time, the development of the infrastructure sector in particular, but also property and various debt related sectors, have increased the non- equity component of the investment company universe to over a quarter. In terms of performance trends, it has meant that the investment company sector is much less sensitive to equity market movements and has become more defensive in character when viewed relative to equity indices. Of course the sensitivity of individual trusts, especially those with equity objectives will remain closely linked to the fortunes of mainstream equity indices, particularly if they employ gearing as part of their investment strategy.

Income Portfolio – Leaders and Laggards

Two of the better performers have been Standard Life UK Smaller Companies 2018 3.5% Convertible Unsecured Loan Stock which rose over 16% and the Invesco Perpetual UK Smaller Companies Investment Trust which gained 5% (both are share price total returns). It is not easy for a portfolio with an income objective to gain exposure to the UK small company sector, as typically most trusts don’t have a high enough dividend yield. In the case of the first, the underlying trust performed strongly and the convertible offered a yield of just over 3%. With the second, its Board took the initiative to supplement the natural yield with a small transfer from the capital reserve so that the dividend yield was 4% at the start of the period. Long term the UK small company sector tends to outperform, so this represents an interesting diversification.

After a period when it lagged the S&P Composite Index (the main benchmark for US equities) BlackRock North American Income produced a rise of 13% in the share price total return as higher yielding large companies returned to favour. It also benefitted from sterling weakness relative to the dollar.

A good indicator of the difficult nature and poor returns from most global equity markets is that the next two best performers are in the infrastructure sector. 3i Infrastructure and GCP Infrastructure Investments generated share price total returns of 11% and 8% respectively. Neither is sensitive to the direction of equity markets and most of their return came in the form of income. The former paid out a special dividend in the course of the year following the successful sale of one its principal investments and has an ongoing dividend yield of around 4.5%, whilst the latter has a dividend yield of 6.3%.

There was a common theme to a number of the principal laggards in the Income Portfolio namely exposure to Emerging Markets and/or the Asia Pacific region. JPMorgan Global Emerging Markets Income Trust declined 17%, Aberdeen Asian Income Fund fell 13%, whilst Henderson Far East Income was down by 11%, all share price total return. The slowdown in China affected the stock markets these funds were invested in, as did the reduction in appetite for risk from global investors. However, it should be remembered the long term attractions of these markets and the strong returns these trusts have achieved in the past. In addition, all of them maintained their dividends which is important as they represent useful income diversifiers for the Income Portfolio.

As explained earlier, during the second half of the year under review, there was a marked widening of discounts in the investment company sector generally, which was also manifest in the UK Equity Income sector. This is a core sector in the investment trust universe and also an important area of investment for the Income Portfolio. Two holdings that underperformed were The Merchants Trust and Temple Bar Investment Trust where the share price total returns were down 13% and 10% respectively. Although net asset values of both were behind the FTSE All-Share Index over the period, it was compounded by discounts widening from close to asset value to high single digits by the end of the year under review. Encouragingly, both trusts actually managed small increases in their dividends and offer attractive yields of around 4% for Temple Bar and over 5% for The Merchants Trust.

Growth Portfolio – Leaders and Laggards

Similar to the Income Portfolio, the best performers in the Growth Portfolio were all significantly invested in UK smaller companies. The leader was Diverse Income Trust with an 11% gain, closely followed by River & Mercantile UK Micro Cap Investment Company which rose 10% and Miton UK MicroCap Trust which was ahead by 9% (all are share price total returns). Diverse Income Trust is an all cap fund which has chosen to invest around two thirds of its portfolio in the small cap sector, whilst the other two trusts specialise in the very smallest listed UK companies. This is an area largely ignored by institutional investors, yet where valuations are most attractive and where, if the right companies with strong management can be identified, then good earnings and dividend growth have led to outperformance.

Standard Life European Private Equity Trust invests in UK and European funds specialising in private companies. In a relatively benign economic environment many private companies have prospered and asset growth has been strong. Because of the perceived risk of investment in this area, discounts on trusts in this sector are wide, often between 20% and 30%. This trust has an experienced management team is well resourced and has a strong balance sheet to take advantage of opportunities. The share price rose 9% in total return terms.

Impax Environmental Markets has been a long term holding in the Growth Portfolio and after a spell of dull performance, has begun to flourish. The share price rose 4% in total return terms. Most of this came in the second half of the year under review, following a major environmental conference in Paris which set goals in a number of key areas for countries to meet. Perhaps unexpectedly, agreement was achieved and this has cleared the way for a re-appraisal of stocks globally in a number of sectors, such as renewables, waste management, filtration etc. Earnings growth is likely to be strong, whilst valuations are attractive.

The principal laggard was Biotech Growth Trust, which fell 23%. After a stellar run of performance, the biotech sector has come in for profit taking as investor sentiment has become more risk averse over the course of the year. Encouragingly the underlying operating companies have produced strong profits and earnings growth. Most of these businesses, which are listed in the US, are sizeable companies, often with billions of dollars of revenues and strong balance sheets. Valuations, particularly in relation to projected growth which is driven by new products, are attractive.

European equity markets have had a difficult past twelve months and trusts invested in this region have experienced a widening of the discount between the share price and the net asset value. This was the case with Henderson European Focus Trust which in share price total return terms, experienced a 10% decline. The trust has an experienced manager with a clear investment approach and have underperformed, not due to poor performance against respective benchmarks, but due to quite sharp widening of the discount. Edinburgh Worldwide Investment Trust, a specialist in global small cap growth companies, declined 10%, and Schroder UK Mid Cap Fund fell 9% in share price total return terms. As investor sentiment has turned more cautious, this has been reflected in a wider discount being accorded to trusts, principally invested in equities, which are perceived as being more risky. In terms of magnitude, the discount move on Gabelli Value Plus + Trust, a trust investing in US equities was the most significant. The trust slightly underperformed the S&P Composite Index but moved from a premium of 2% to a discount of 11% during the year under review. This resulted in a share price decline of 10%, in total return terms.

FMPG / FMPI : F&C Managed Portfolio beats benchmark despite widening discounts

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