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Edinburgh Investment Trust held back by lack mining exposure, HSBC and Royal Dutch Shell

Edinburgh Investment Trust held back by lack mining exposure, HSBC and Royal Dutch Shell. While the UK market returned 22%, for the year ended 31 March 2017, Edinburgh Investment Trust’s net asset value total return was +14.4% and the share price total return (with dividends reinvested) was +11.2%.

The share price ended the year at 713.5p, an increase of 7.3% from the previous year end price of 665p. With debt at market value, the discount moved out from 4.4% to 7.2%, reflecting the general widening of discounts in the peer group over the same period. The board wishes to continue its aim to rebalance the interim and final dividends towards the interims whilst at least maintaining the final dividend. However, notwithstanding this medium term objective, the decision was taken this year to increase the final dividend by more than the percentage increase in the interim dividends to enable shareholders to benefit from the current year’s particularly buoyant net revenue return. Consequently, for the year to 31 March 2017 the board has declared three interim dividends of 5.4p (2016: 5.2p) and recommends a final dividend of 9.15p (2016: 8.75p) per share. This increases the total dividend to 25.35p for the year, an increase of 1.0p on last year’s total dividend of 24.35p. The total dividend increase of 4.1% is in excess of the annual increase in the Retail Price Index of 3.1%.

Manager, Mark Barnett reports that “Against a strong market backdrop, the portfolio’s performance was held back by its zero weighting in the mining sector and by the absence of holdings in HSBC and Royal Dutch Shell. These share prices rose strongly, benefiting from weakened sterling and, in the case of Royal Dutch Shell, from the recovering oil price. The zero weighting in UK domestic banks was, however beneficial to portfolio performance.

The absence of mining stocks had benefited the portfolio’s performance over the previous two years, but the recovery across the sector in the past year meant that the portfolio missed out on one of the major positive trends of the past 12 months. While perhaps not a bubble, the valuation of the sector now looks extended and vulnerable to a pull-back in key commodity prices. Supply discipline has improved following the shock of the 2011-2015 downturn, but demand growth in China remains under pressure. I am not planning to change my position and expect some unwinding of the recent commodity share price gains.

The holdings in the tobacco sector again delivered a strongly positive contribution to performance – despite a lack of enthusiasm for “bond proxies” (companies offering low stable growth, steady dividends and low volatility) that prevailed for much of the period. The sector was boosted by M&A activity, with a proposed merger of two of the portfolio’s largest holdings. Reynolds American accepted a cash and shares offer from British American Tobacco, creating a combined entity which is well positioned to exploit next generation products, particularly the US e-cigarette market. The deal is expected to be concluded in Q3 2017. I expect Tobacco companies to continue delivering cash flow and dividend growth while valuations remain discounted relative to other staples and corporate activity is still very much on the agenda.

AstraZeneca also performed strongly over the period. Chief executive Pascal Soriot characterised 2017 as a potential “inflection point” for the company’s return to long-term growth, with the upcoming launch of several “life-changing” medicines for cancer, respiratory and metabolic diseases built on the “solid foundations of a science-led pipeline”. The European pharmaceutical sector as a whole did not perform well in 2016 as the market focused increasingly on the risks associated with new product trials, the overall pricing environment in the US and the challenge of replacing mature drug portfolios. My view on the long term outlook has not changed; the de-rating of the sector suggests that major companies succeeding in bringing genuinely innovative drugs to market could see a meaningful boost to their share prices and to the portfolio’s holdings across the sector.

Other significant positive contributions to portfolio performance came from the holdings in BP, Burford Capital, Compass, G4S, Homeserve, Raven Russia, RELX and Rentokil Initial.

The portfolio’s holdings in companies particularly exposed to the fall in sterling and perceived challenges to the UK economy performed poorly in the
aftermath of the referendum. The stock market was also inclined to de-rate companies which warned of lower profits – delivering a “double-whammy” impact on the share price via a fall in both earnings and P/E ratios.

Notable amongst these was the holding in Capita, which fell sharply in value as it downgraded full-year earnings forecasts, blaming a slow-down in specific trading businesses, one-off costs and problems with a major contract with TFL, along with delayed client decision-making since the EU referendum. The company later confirmed the departure of its chief executive Andy Parker and expects 2017 to be a “transitional year” for the business, as it completes a number of disposals, embeds internal structural changes, and re-positions for a return to growth in 2018.

The holdings in the travel sector – easyJet and Thomas Cook – warned of the negative impact of weaker sterling and were additionally impacted over the period by concerns over terrorist activity and by air traffic control strikes. The share prices of both companies rose into period end, as they confirmed more positive trading updates than had been feared by the market and on the back of some renewed sterling strength.

BT detracted from performance – an update on accounting irregularities in the group’s Italian division prompted a sharp sell-off, which worsened after a profit warning from the company highlighted a more challenged outlook for domestic public services contracts. Towards the end of the period, the group was also hit by a record fine for cuts in broadband delay pay-outs.

The portfolio’s new holding in Next weighed on performance, following a disappointing Christmas trading update. Into the end of the period, however,
Next’s share price rose as the company maintained its profit outlook for 2017, despite a challenging clothing market.

The share price of Circassia fell sharply on news that its cat allergy drug had failed to meet the primary end point of phase III trials. While this was very disappointing and surprising news – the drug had performed well in Phase 2 trials – it is noteworthy that Circassia retains significant cash on its
balance sheet and that, over the past year, the company has also made significant diversification into respiratory drugs, devices and technologies.
Confirming this, Circassia saw its share price rise in March as it confirmed a new strategic collaboration with AstraZeneca in combating respiratory disease.

Other domestically focused holdings to deliver negative share price performance included Derwent London, N. Brown, Game Digital, Secure Trust Bank and TalkTalk Telecom.

EDIN : Edinburgh Investment Trust held back by lack mining exposure, HSBC and Royal Dutch Shell

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