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Large cap focus restrains City of London

Large cap focus restrains City of London – City of London Investment Trust has published results for the year ended 30 June 2017. Its returns fell behind those of peers and index benchmarks over the period. City of London’s net asset value total return was 14.5% which was 3.3% behind the size weighted average over the twelve months for the AIC UK Equity Income sector, 3.6% behind the All-Share Index and 4.9% behind the UK Equity Income OEIC sector average. The chairman’s statement says that the key factor behind City of London’s underperformance relative to competitors was having less invested in medium-sized and small companies.

Compared with the All-Share Index, he says that the biggest sector detractors were underweight positions in banks and mining. Both these sectors have been poor dividend payers in recent years and so do not feature much in the portfolio. On a more positive note, the position in housebuilders was the biggest contributor with the best performance from Persimmon which returned 64.4%. Overall, stock selection detracted 3.84% from performance. Gearing, which started the year at 8.0% and was reduced to end the period at 5.5%, contributed 0.61%. The fair valuing of the fund’s 4.53% 2029 Notes had a negative 0.54% impact.

The undeperformance did not seem to dent investors’ enthusiasm for the company. 14.2m shares were issued at a premium to net asset value, for proceeds of GBP57.1m.

on 15 September 2017, City of London raised GBP50 million of fixed rate 32 year private placement notes at an annualised coupon of 2.94%. The notes are repayable on 17 November 2049.

Job Curtis’ manager’s report says that the three housebuilders held in the portfolio did well. Persimmon produced a share price return of 64%, Taylor Wimpey 41% and Berkeley 37%. He says that all three companies have large land banks, acquired at attractive prices, so are well placed to fulfil some of the demand for UK housing going forward. In addition, the holding in Ibstock, the leading UK brick maker also benefited from the robust demand for new homes and performed strongly with a return of 96%. New investments were made in two housing related Real Estate Investment Trusts which offered an attractive dividend yield: Civitas Social Housing which invests in social houses and PRS which invests in private sector rental houses.

The second biggest sector contributor was pharmaceuticals where the portfolio had a below average market exposure to GlaxoSmithKline and AstraZeneca. Both companies are in the process of replacing old medicines which have lost their patents with new drugs that they have researched and developed. Given the opportunities available globally in the sector, three overseas pharmaceutical companies are held: Merck and Johnson & Johnson of the US and Novartis of Switzerland. Merck had a particularly successful year because it has emerged as the world leader in immunotherapy, a type of cancer treatment that boosts the body’s natural defences to fight cancer. Bristol Myers Squibb had a disappointing drug trial in this field and was sold. In the health care equipment sector, a new holding was bought in Smith & Nephew, which is focussed on surgical devices, such as knee and hip implants which have favourable demographics with the ageing population.

The third biggest sector contributor to relative performance was the below average exposure to oil and gas producers. Both Royal Dutch Shell and BP have been making dramatic changes to their cost base in order to afford their dividends at the lower oil price level. In addition, the benefits from Royal Dutch Shell’s acquisition of BG began to come through.

The sector which detracted most from performance was banks. Although HSBC was the third largest holding in the portfolio, the exposure was below the market average. Confidence built in HSBC’s capital position and with its large US deposit base it benefited from the rise in US interest rates. Additions were made to Lloyds Banking where the capital ratios are much improved. It delivered attractive dividends and moved over the year from twentieth to ninth largest holding.

The second biggest detractor was mining where Rio Tinto and BHP Billiton were held but overall the portfolio was significantly under represented relative to the market average. Rio Tinto produced a return of 47% and BHP Billiton 28%.The profits of the miners are dependent on commodity prices and dividends have been variable with cuts during downturns. Over the twelve months, iron ore, which is particularly important for BHP Billiton and Rio Tinto, traded between $54/metric tonne and $95/metric tonne. This level of the iron ore price enabled Rio Tinto and BHP Billiton to generate significant cash flow and reduce debt.

The third biggest sector detractor was gas, water and multiutilities. Utilities were adversely affected by the preference for more cyclical stocks as economic growth picked up globally. In addition, there was nervousness ahead of a water sector regulatory review in 2019. The closer than expected general election result was a further negative given that the Labour Party manifesto had committed to nationalising some utilities. It is hard to see the UK benefiting from utilities returning to state ownership with the significant investment needed in electricity, gas and water infrastructure and the continued improvements in efficiency made over the years by private companies under independent regulation. A large holding was maintained in National Grid which has some 40% of its operations in the US.

The low level of government bond yields was also supportive of commercial real estate. There were some record purchases of trophy office buildings in London from overseas purchases benefiting from the lower level of sterling. However, share prices stayed at discounts to net asset values for Real Estate Investment Trusts (REITs) focussed on office and retail property, reflecting concerns about future rental and capital growth. Given the quality of income from leading REITs with strong tenants on long leases, holdings were maintained in the sector. The holding in GCP Student Living, which owns student accommodation and had performed very well, was sold on a premium to its net asset value.

Retailers underperformed partly due to cyclical factors with the squeeze on consumer spending caused by prices rising faster than wages. Structural factors were also a factor with the rise of internet retailers, such as Amazon, displacing traditional high street retailers. The high degree of investor pessimism on the prospects for retailers was reflected in low share price valuations which offered an opportunity in well managed, competitive retailers.

The holdings in Capita and Interserve were sold after they both surprised negatively and had relatively high levels of debt. Berendsen, the textile cleaning service company, had a profits warning relating to its UK operations. Subsequently, it had a takeover approach from Elis of France and the holding was sold.

Rolls-Royce also disappointed partly due to downgrades of profitability on the long-term maintenance contracts associated with the aircraft engines that it sells. With its dividend having been reduced, the stock was on a low yield and was sold.

CTY : Large cap focus restrains City of London

 

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