Law Debenture Corporation protects against almost 40% of market decline

Law Debenture Corporation (LWDB) has announced its annual results for the year ended 31 December 2018. For those not familiar with its structure, LWDB is a unique combination of an equity portfolio and independent professional services business. Key highlights for the Group, the equity portfolio and the independent professional services business are provided below, but a key takeaway is that LWDB’s NAV total return outperformed the benchmark, protecting investors from almost 40% of the market decline. The trust also has a 40 year record of increasing or at least maintaining its dividend. Since the year end, LWDB has provided an NAV total return (to 22^nd February 2019) of 6.7%.

Group highlights

• Total proposed dividend of 18.90p per share for 2018 (2017: 17.30p), a 9.2% increase
• Strong performance from the Independent Professional Services (IPS) business continues to support dividend growth
• Katie Thorpe, Chief Financial Officer, was appointed to the board on 1 January 2019
• Low ongoing charges of 0.43%

Investment portfolio highlights

• Net asset value (NAV) total return outperformed the benchmark, protecting investors from almost 40% of the market decline
• NAV as at 31 December 2018 was 614.07 pence
• The portfolio has consistently outperformed its benchmark on a one, three, five and ten year basis:

• Transitioning to a UK sector AIC category from current global sector classification later this year to better represent portfolio positioning

Independent Professional Services (IPS) highlights:

• Revenues increased 9.0% to £29.6m (2017: £27.1m) following strong performance from all three divisions: Pensions, Corporate Trust and Corporate Services
• IPS normalised earnings per share increased by 9.2% to 7.87p (2017: 7.21p)
• IPS has provided almost 40% of total annual dividend payments to shareholders over the last 10 years
• New management team in place to drive growth and enhance shareholder returns
• Board remains committed to growing the business over time and increasing transparency

Commentary from James Henderson, Investment manager the equity portfolio

Review of 2018

As the Chairman said in his statement, we are satisfied with our relative outperformance of the benchmark against a backdrop of troubled and volatile markets. Over 2018, the FTSE All-Share declined by 9.5%, while the Company’s net asset value declined by 5.8% on a total return basis. As a manager aiming to grow capital over time, it is never comfortable to report a decline in net asset value. I am, however, content that our bottom up approach to owning quality companies has sheltered the portfolio from almost 40% of the overall market decline.

Top five contributors

The following five stocks produced the largest absolute contribution for 2018:

Source: Bloomberg calendar year share price total return (in the case of GKN and Sky, until point of acquisition).

The two largest contributors to return during the year were GKN and Sky, both of which were taken over at a material premium to the prevailing share price at the time of acquisition. The valuation level in the UK market (along with the low value of sterling) may well lead to further corporate activity if the UK market is not re-rated closer to global markets.

The holding in Microsoft was also a strong contributor to performance. As noted above, we have the flexibility to allocate overseas where there is no equivalent company in the UK. The position was purchased in 2011 (for $24 per share), when there were structural concerns regarding the decline in use of desktop computers and the impact this would have on businesses providing their operating systems and software. Under a (relatively) new management team, Microsoft has successfully transitioned the business towards a ‘cloud’ based subscription model and, as a result, the shares have re-rated materially and were trading at $101 at the year end. We have recently been reducing the position as a result of the higher valuation, but it remains 1.5% of the portfolio at the end of December.

Top five detractors

The following five stocks produced the largest negative impact on the portfolio valuation for 2018:

Source: Bloomberg calendar year share price total return

The largest individual detractor from returns was Fastjet, which is aiming to roll out a low-cost airline in Africa. While there is substantial unmet demand for a low-cost carrier serving the African market, Fastjet had to exit its core Tanzanian market when the state-owned carrier added substantial new capacity at an uneconomic return. As at the end of December, Fastjet was 0.1% of the portfolio. Although the position has been disappointing, it demonstrates the importance of running a long, diversified list of holdings in our portfolio.

Although a detractor in 2018, DS Smith, a cardboard packaging company, has been a strong contributor in previous years. It has undertaken a number of successful acquisitions under its current chief executive, entering first the European market and more recently the American market. The shares were weak in 2018 on concerns about a broader economic slowdown and at a company level the amount of debt taken on. The end markets are cyclical, but DS Smith is a far better business than it was going into the previous downturn and, in our view, this is not reflected in the current valuation.

We have maintained our holdings in DS Smith and other stocks where we believe our investment thesis holds true. We have used periods of weakness to selectively add to certain positions bringing our gearing from 1% at the start of the year to 3% at the end.

Attribution

Since the referendum vote in June 2016, the UK stock market has significantly underperformed other major global markets.

This is in contrast to the twenty years before where UK and world markets performed roughly in line.

In a historical context, the UK market therefore appears to offer significant value. Price earnings ratios for UK companies with positive earnings in the FTSE All-Share were an average of 11x for the 12 months ending 31 December 2018, compared to 13.6x for Europe (excluding the UK) and 16.5x for the US. Looking at dividend yield, UK companies in the FTSE All-Share had an average yield of 4.72% as at 31 December 2018, compared to 3.70% for Europe (excluding the UK) and 2.15% for the US.

We are retaining our exposure to the UK and adding to certain positions on days of market weakness, as explained below.

Portfolio activity

What I’ve been buying

During the year, purchases were predominantly in the UK market, many of which can be characterised as global companies listed in the UK. The UK market has materially underperformed global markets in recent years, which has left many good quality companies trading at a discount to both global peers and their recent history. An example of this is insurer and asset manager Prudential, which was added to during the fourth quarter at under 10x current year earnings.

We used the market weakness towards the end of 2018 to be net investors, adding to existing holdings, including pub operator Greene King, cruise operator Carnival and retailer Dunelm. We also for the first time in recent years added a new position in a UK house builder (Taylor Wimpey). The shares had de-rated to near book value, which historically has been a good entry point for the sector. The balance sheet has also improved materially since the financial crisis. This remains a small position (0.3% of the portfolio) but we expect to add to the position opportunistically if presented with further market weakness.

The largest new holding during the year was Kier Group, a contractor and support services provider, which demonstrates characteristics of quality but which has fallen out of favour with the market. This was purchased at £3.60 subsequent to the rights issue in December 2018, which we felt presented an attractive entry point. Following a number of poor performers in the sector, there has been a push among both the market and lenders for companies to operate with less debt. The £250m rights issue provided Kier with a much stronger balance sheet, while underlying

operations have not deteriorated. Kier has not historically entered into large fixed cost contracts outside of its areas of expertise, which has proved a problem for peers when they have overrun on costs and impacted profitability. Kier has instead focused on smaller contracts where it continues to generate good margins.

Also among the largest purchases was one of the UK’s water utilities, Severn Trent. Along with many shares that are focussed on the UK, it has de-rated versus recent history. As a result, it is currently paying an attractive 5% dividend yield, with a dividend that is expected to grow above the rate of inflation. Severn Trent is among the best in the sector in terms of operational performance, with a well-invested network. In our view, this was not reflected in the valuation.

What I’ve been selling

The largest sale during the year was aerospace and automotive supplier GKN, which was sold following a takeover from Melrose at a substantial premium. GKN had been a long-held position in the portfolio, having been purchased originally in 2006 at just below £3 and then added to substantially during the financial crisis at 89p in an emergency rights issue. The position was sold at approximately £4.30 early in 2018, providing a total shareholder return of 53.2%. We continue to retain positive exposure to the ongoing development of the civil aerospace sector through our remaining holdings in Senior and Rolls-Royce.

During the year we exited two of the overseas investment trust holdings, Schroder Japan Growth and Templeton Emerging Markets. In the case of Schroder Japan Growth, we purchased the position in 2016 at a double digit discount to net asset value and sold the position following strong portfolio performance and a narrowing in the discount level. Templeton Emerging Markets was sold due to concerns about the outlook for emerging markets. Broadly, we aim to use investment trust and other collective investment holdings to gain exposure to specialist areas. For example, we continue to have a holding in Herald Investment Trust, which brings exposure to emerging technology companies. It has been a strong performer since purchase and provides access to an area of the market to which otherwise we would not have been exposed.

Outlook

Economic forecasting for the UK continues to be difficult. A large unknown looms in ‘Brexit’ and what it means for business is unclear. The global economy appears to be slowing and UK productivity growth remains disappointing. The dark clouds are considered to be mounting for the UK by many commentators. However, the UK companies we hold are not a proxy for the UK economy; they are strong businesses with good management teams. They are good at what they do and provide competitive products and services; they also earn around 65% of their revenues outside the UK. The negative sentiment towards these businesses has become extreme, which has made valuations and the dividend yield attractive. The intention over the next few months is to move the gearing up by buying UK stocks to take advantage of this dislocation. The US holdings have in aggregate performed well and where the valuation looks stretched they will be further reduced. The UK companies purchased serve a diverse number of end markets and we will likely add to existing holdings. It is important to use the weakness to position the portfolio for an improved investment background.

Commentary from Denis Jackson, CEO, on LWDB’s Independent Professional Services Business

Our IPS business is a key differentiator between us and other investment trusts. As the Chairman explains in his statement, the IPS earnings have covered almost 40% of total annual dividend payments in the past ten years, allowing James increased flexibility in portfolio construction.

Following many meetings in 2018 with brokers, wealth managers and shareholders, it is clear to me that we have more work to do to explain our differentiated investment proposition. It is incumbent on us to better explain both the nature of the professional services that we provide, and the inherent value of IPS to our owners.

Our stated objective is “to achieve long term capital growth in real terms and steadily increasing income”.

Between 2011 and 2017, IPS earnings were flat. While we score highly for consistency, net operating margin and return on capital employed, we have failed to register growth and we need to address that. I am pleased to report some steps in the right direction in this regard in 2018.

IPS normalised earnings per share increased from 7.21 pence per share in 2017 to 7.87 pence in 2018, a 9.2% increase. Revenue (net of cost of sales) increased from £27.1m to £29.6m, an increase of 9.0%.

We are confident we can grow the IPS business considerably over time, while preserving our quality of product, outstanding client outcomes and our hard won reputation.

Our leading independent professional services provider is built on three excellent foundations; our pensions, corporate trust and corporate services businesses.

The table below sets out the revenue by division net of cost of sales for the past three years, alongside a percentage growth number compared to prior year:

1 This relates to revenue earned by the US corporate trust business that was discontinued as at 31 December 2016 and a dividend received

from Nordic Trustee Holdings ASA which was sold during 2017.

Taking each business in turn:

Pensions

2019 marks the 50th anniversary of our first pension fund client, Demerara Sugar. While the landscape has changed considerably, the fundamental value proposition of a qualified independent pension trustee has not. Many of the reasons for our appointment to Demerara Sugar are as true today as they were 50 years ago: ensuring proper and professional governance; the need to protect against abuse of schemes; and the deployment of an effective strategy to communicate fair management of a scheme and its benefits to a sometimes sceptical workforce.

Market dynamics

No one particularly likes to save for their pension but almost everyone wants to retire one day. Add to this the irresistible demographics of an ageing population and a growing middle class. Overlay this conundrum with the need of the government to put in place tax incentives for people to save in the long term while maintaining tax revenues in the short term. Top this off with the political desire of successive Chancellors of the Exchequer to “solve this once and for all” by introducing yet another refinement to our pensions legislation and we are left with (positive metaphors only) a simply delicious plate of spaghetti for trained professionals only to devour, lest the public choke on the same ingredients.

Politically agnostic, we echo the cries of “hear, hear” in the Commons Chamber with our own “well, well” as successive governments add to the complex web to be untangled.

We currently deal with around 200 Defined Benefit schemes out of around 5,500 schemes in the UK. We firmly believe that the next 10 years will see an increasing trend towards consolidation of these 5,500 in order to optimise operating efficiencies and enhance governance structures given the common problems that many share. Even after consolidation, a market share of 3.6% leaves plenty more schemes to serve and support.

Highlights

The single most important driver of success in professional services is quality of people and, in 2001, we recruited Mark Ashworth. Today, Mark sits at the top table of the profession in the UK and thankfully he too recruits well. Michael Chatterton joined us in 2010, and between them Mark and Michael lead a team that is rightly viewed by its clients as the leading UK independent pension trustee. Our trustee team has grown by 20% over the past two years, as we recruit outstanding commercial professionals from a rich variety of backgrounds.

In 2018, we started to see returns from that investment in people, with revenues up 14.7% from £8.3m to £9.5m. This is a very pleasing result that we are looking to build on in 2019 and beyond.

2018 also saw the launch of our pensions governance business, PEGASUS. There is a recent trend towards the appointment of sole corporate professional trustees, rather than a traditional multi trustee board model. Growing regulatory focus on the sector as a result of the fallout of several high profile corporate and pension failures, has seen lay trustees facing increased pressure, accountability and responsibility. With wins of five additional sole trusteeships in 2018, our provision of sole trustee solutions is now beyond critical mass.

Key client wins for this year include Clara Pensions, Optivo, Smart Pension and Standard Life Aberdeen.

Outlook for our pension business

As we look forward, the long-term decline in the Defined Benefit market is well aired, albeit one that has many years to play out given the long term nature of liabilities to be funded. Accordingly, we believe that the growth in importance of our Defined Contribution (DC) work relative to our total revenues will continue. The considerably increased number of DC appointments in recent years provides us with tangible evidence of this and, while we have an enviable roster of larger clients, our ability to create solutions for the mid-market and to support consolidation type solutions at the smaller end will help drive growth.

In the meantime, I would like to thank Mark and Michael for their outstanding leadership of this business and the whole team for their unstinting professionalism. We are fortunate to have them.

Corporate trust

This business led to the creation of Law Debenture nearly 130 years ago. Our longest appointment is for a share trustee role in 1889, the year in which Law Debenture was founded. This appointment remains in place today.

Our duty as a corporate trustee is to act as a bridge between bondholders and a bond issuer. The trustee’s role and income stream can vary greatly between “non-defaulted” and “defaulted” bonds.

In non-default situations, the trustee is typically paid an (inflation linked) annual fee to discharge its duties throughout the lifetime of the bond. We started 2018 with more than two-thirds of our £8.4m annual revenue contractually secured, with an overall inflation linked increase of 1.5% on those same contracted revenues in 2017.

In addition, the trustee becomes involved when amendments to deal with documentation or waivers are required.

This will often be separately remunerated and provides us with an additional income stream, which represented 19.5% of our corporate trust revenue for 2018.

In default scenarios, the revenue and risk profile of the trustee often shifts substantially. A key role of the trustee is to be the legal creditor of the issuer on behalf of the bond holders. This can require material extra work that, given an optimum outcome, can lead to significant additional income. However, default scenarios can take years to play out and have uncertain outcomes. The trustee is at risk if it is subsequently judged not to have discharged its duties appropriately.

Our corporate trust team are conservative and careful in taking on new business, and operate in an environment that has long prioritised these qualities. This highly disciplined approach has produced consistent profits for over a century. Our shareholders should understand that swings in our revenue (and in turn profit) can result from adopting a prudent approach to provisioning, as long term defaults work their way to a conclusion.

Market dynamics

Our corporate trust business is a leading independent player; however, the market is highly competitive, particularly as a result of the emergence of multi-service offerings by global banks. Eliot Solarz was appointed to head this team on 1st January 2018 and leads by example as we look to accelerate our growth.

Happily, as with all of our businesses, Eliot has strong foundations on which to build; we consistently receive excellent feedback from clients for our technical knowledge, speed, quality of service and willingness to innovate. We pick our spots carefully and play very much to our strengths.

All bond trustees love an appointment to a standard investment grade corporate bond and we are no exception. We are thrilled when issuers such as Vodafone, Unilever or NatWest appoint us as their trustee. But we have learned long ago that by moving off the beaten path a little, there are more complex products that are well served by our deep technical knowledge and our ability to move fast.

A particular focus is in infrastructure and “real asset” businesses e.g. transportation, energy and real estate. Short-term issuance in these sectors will ebb and flow but as a long-term proposition, experience tells us that global demand for capital in these areas is almost bound to continue to increase. Indeed, we first acted in this space for The Kansai Railway Company in Japan in 1905.

A more recent example is Mutual Energy’s 35 year Gas to the West project, which was launched in 2018. This is to finance the extension of a gas network in Ireland, where we provide security trustee, noteholder agent and registrar services. There are other smaller niches, where a deep expertise, reputation for quality and excellence in service delivery among specialist issuers and specialist arrangers serve us well.

Highlights

We took on 250 trustee engagements in 2018, acting as trustee to bonds with an issuance value of close to £600bn. We booked revenues of £0.8m in 2018 for these contracts, a small fraction of the full value over their life cycle of around £10.8m. The majority of that future revenue is index linked. We now have around 1,800 trustee roles on our books for bonds with over £1.8tn of value.

Corporate trust’s net increase in revenues for 2018 was 5.8%, with total revenue increasing from £7.9m to £8.4m. Our new business fees earned in 2018 were the second highest recorded since the global financial crisis and at £0.8m were 24% higher than new business fees earned in 2017.

This increase was partially offset by a net addition to reserves of £0.3m across our book of transactions working through various stages of the default journey. Our aim is to recover these amounts in the future, but, as is almost invariably the case, quantum and timing of that recovery remains uncertain.

Key client wins for this year include Unilever.

Outlook for our corporate trust business

The long term nature of appointments in the corporate trust universe provides a stable and index linked source of revenue for the group. As highlighted above, only a small fraction of the value of contracts won in a given financial year will benefit that year’s profit and loss account. Our aim is to consistently win new business in both the standard investment grade space and the niches where our speed and agility provide us with a significant advantage.

Corporate services

Corporate services provides outsourced solutions across a continuum of company directors, company secretarial, accounting, corporate administration and facility agent services. These services are provided largely, but by no means exclusively, to corporates and special purpose vehicles.

Market dynamics

The traditional securitisation aspect of this market has not yet returned to its pre-financial crisis peak, but nevertheless

the marketplace remains fiercely competitive. We continue to put great effort into building our relationships with arrangers, advisers, sponsors and end users. We are confident over time that, as with all of our businesses, our high quality service, underpinned by outstanding technical knowledge, relentless focus on client delivery and willingness to innovate will yield an incremental stream of repeatable earnings.

We provide a highly regarded global service of process business that had a solid year in 2018. Led by Anne Hills, it has a market leading reputation with law firms in London, New York and Hong Kong.

Highlights

Revenue from these businesses grew from £11.0m in 2017 to £11.7m in 2018 an increase of 6.9%.

This year, the corporate service offering that I would like to highlight is relatively small but our fastest growing: our provider of independent whistleblowing services, Safecall.

Based in Sunderland, Law Debenture acquired Safecall in 2007, following its establishment 20 years ago by Alan Long, a former police officer. It has been expertly led since 2004 by his son Graham Long. He and his team have delivered a 15.4% increase in revenue in 2018 and a 44% increase in revenue over the past three years, with revenue for 2018 exceeding £1.6m for the first time.

Ethics and compliance have leapt onto the front page in 2018, following the multitude of revelations that, unfortunately for many, have come to light too late. Safecall provides an independent, confidential, anonymous (if desired) route to raise issues to the highest levels of organisations that can see that line management chains sometime fail and senior people don’t always meet expected standards of behaviour.

We believe the team at Safecall offers a product superior to their competitors at a competitive price point. This is supported by Safecall’s ownership structure. Where competitors are almost exclusively private equity backed and focused on extracting value, we are interested in the long-term success of Safecall, underpinned by the quality of the service provided by our highly trained call handlers.

Safecall took on 72 new clients in 2018. The team now support over 400 organisations, employing anywhere between 25 and 80,000 staff, on a truly global basis, covering 100+ languages. We currently act for 41 companies within the FTSE350, with significant growth ambitions for this market.

Key client wins for this year include ARaymond, Bird & Bird, Mazuri International, Nuffield Health, OCS, Rubix and The FA.

In addition to achieving excellent growth in 2018 we have also made strategic investments to set Safecall up for future success. We launched a new website, built a new case management solution as a service offering (SaaS), and have added headcount in business development, technology and client service. More information is available at www.safecall.co.uk.

Investment in technology

2018 has seen a strong focus on advancing the use of technology across IPS in order to improve the service that we provide to our clients, be that introducing additional functionality, enhancing security or reducing costs by delivering efficiencies in our operations.

The primary goal of the application of technology is to further enhance the characteristics that make the IPS business a unique proposition; responsiveness, speed, flexibility, discretion and delivery. We are also aware that key to our value proposition is the expertise of our people. We see technology as a way to enhance our capabilities, enabling our people to do more and faster to help deliver increased revenue, scale and control.

During 2018 we appointed David Williams as Chief Technology Officer (CTO). David is the former CTO of Marshall Wace LLP and Tibra Trading. We have also hired five full-time technical experts to facilitate delivery of high quality technical solutions. This new team has already delivered a new technology platform for Safecall, a new website for both Safecall and Law Debenture; a new collaboration platform and secure file sharing service for our pensions trustees. Many more valuable initiatives are at various stages of delivery across a rolling two year plan.

Prospects

2018 was a year of change and investment for the IPS business, putting in place the foundations for future growth. Looking ahead, I am excited about future prospects. After nearly 130 years, Law Debenture remains focused on building on its reputation for delivering long-term income and capital growth. I’m encouraged by the progress already made by the IPS business in the last year and the outstanding team we now have in place to help future opportunities. We will also remain alert to any prospective acquisitions that would offer accretive value to shareholders without diluting our core brand and strengths.

For ten years, IPS has accounted for almost 40% of total annual dividend payments, which has allowed James Henderson greater flexibility in the equity portfolio’s stock selection. The continued performance of IPS and its attractive, recurring revenues will continue to support our ambition to increase the dividend for the benefit of our shareholders. The move to a UK sector AIC category from the current global sector classification will better reflect

Law Debenture’s overall investment proposition. The board and I remain confident in James’ ability to position the equity portfolio for future growth.

About Law Debenture Corporation

Law Debenture Corporation was originally incorporated in 1889. It has been listed on the London Stock Exchange since July 1946 and has a premium main market listing. It is somewhat unusual in that, as well as being a global equity investment trust (managed by James Henderson), it also has a wholly owned independent fiduciary business. This is a separate trading company that makes its money by being the corporate trustee for a variety of structures (like corporate bonds and pension funds) and also has various corporate governance, whistleblowing, escrow and corporate services businesses.

The profits from the fiduciary services business go to boost Law Debenture’s dividend. Historically, the business was valued at book in Law Debentures accounts and so it tended to trade at a premium to NAV reflecting the value that investors put on the fiduciary services business. However, in recent years, it has attempted to put a market value on the business in its accounts, and so it now tends to trade at a discount to net asset value.

Law Debenture’s equity portfolio aims to achieve long term capital growth in real terms and steadily increasing income. The aim is to achieve a higher rate of total return than the FTSE Actuaries All Share Index through investing in a portfolio diversified both geographically and by industry. The equity portfolio is managed by James Henderson of Janus Henderson Investors. Laura Foll has assisted James in running the portfolio since 2011.