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Edinburgh board sticking by Mark Barnett

Edinburgh board sticking by Mark Barnett – Edinburgh Investment Trust generated a 2.9% return on NAV over the year ended 31 March 2019, 3.5% behind the return on the All-Share Index. The return to shareholders was 4.6%, aided by a small narrowing of the discount to 7.6%. The dividend for the year is 28p, up 5.3% over the previous year.

The chairman notes that this is the third year in a row that the trust has underperformed its benchmark but points out that it has outperformed over five years and delivered dividend growth ahead of the rate of inflation over that period. The chairman and the rest of the board say that they have reviewed Mark Barnett’s approach to managing the fund and that they are happy with it.

[QD comment: Since 31 March, EDIN’s shares have slipped from 644p to 592p and the discount is now 13.7%. The NAV isn’t off much but the move reflects a fear that the collapse of Woodford Investment Management will have a knock-on effect on this trust, which Neil Woodford used to manage and which still retains many of the investments that he bought. QuotedData’s James Carthew wrote an article on Edinburgh’s sister trust, Perpetual Income & Growth, for Investment Trust Insider fairly recently, which discusses some of the performance problems that these funds have been experiencing. Much will depend on the outcome of Brexit, of course, but shareholders may be restless if the year to 31 March 2020 turns out to be another year of underperformance.]

Extract from the manager’s report

The Company’s net asset value, including reinvested dividends, provided a return of 2.9% during the period under review, compared with a return of 6.4% (GBP total return) by the FTSE All-Share Index.

The portfolio’s themes have remained broadly consistent over the past year. The tilt towards UK domestic opportunities has been emphasised, as persistent negativity towards domestic sectors has created further opportunities, whilst exposure to more internationally orientated growth stocks has been modestly reduced. Exposure to the tobacco sector remains prominent, and a significant proportion of the portfolio is invested in non-correlated financials, a theme which offers the portfolio both risk diversification benefits and diversified sources of income.

The portfolio’s exposure to UK domestic opportunities supported absolute performance over the period, as stock selection proved crucial across a range of sectors. Most notable was the holding in Next, which defied the well-publicised crises facing many high-street retailers to deliver full-year results in line with expectations. The 15% rise in online sales offset more challenging declines in in-store retail sales, emphasising that the company’s multi-channel offering allows it to see the growth of online shopping as an opportunity not a threat. Meanwhile the 4.5% increase in the annual dividend reaffirmed the company’s focus on shareholder returns. Holdings in Drax, Tesco,
Legal & General and BCA Marketplace further supported returns.

Sterling weakness and prolonged political uncertainty saw the internationally orientated companies of the FTSE All-Share Index outperform. Stock selection within this theme contributed to the portfolio’s relative underperformance over the year. The portfolio’s zero weighting in the metals and mining sector detracted from relative performance. Mining companies have historically paid dividends from current earnings, which are highly correlated to commodity prices. Given the inherent volatility underpinning earnings within the sector, I believe there are alternative areas of the market better-suited to the objectives of the portfolio.

Elsewhere, the leisure sector faced some challenging trading conditions during the period. The portfolio’s positions in Thomas Cook and easyJet suffered as a result of rising oil prices, an unusually hot summer across Northern Europe and the Brexit impasse, which impacted demand within the sector.

The portfolio has a significant weighting in the oil & gas sector, namely in BP and Royal Dutch Shell, which performed well over the period. BP provided the portfolio’s strongest contribution to performance, releasing better-than-expected results for 2018 in February. I believe that the sector’s outlook is dependent on the market’s confidence in these companies’ ability to cover their cash flow and dividends. Unlike other sectors, I believe that this is reliant on capital discipline within the sector, rather than price strength in the underlying commodity.

In absolute terms, the portfolio’s standout return was provided by holdings in international healthcare stocks as Roche, Novartis and BTG which provided a strong positive contribution. Roche and Novartis traded strongly over the period, whilst the share price of BTG rose sharply in November, as the company accepted an offer from US biopharmaceutical firm Boston Scientific. The portfolio’s holding in AstraZeneca also supported absolute performance over the period, although the decision to sell the position mid-way through 2018, coupled with the non-inclusion of GlaxoSmithKline, proved challenging for relative returns.

Other notable contributors included HomeServe. The emergency home repairs and services provider released strong full-year results in May 2018, which included a 25% increase in the company’s dividend following a year of “record profit growth”. The company’s share price continued to trade positively, supported by a positive trading update in July 2018, analyst upgrades and an acquisition.

Tobacco remains a prominent theme, with investments in Altria, British American Tobacco (BAT) and Imperial Brands, which have delivered exceptional returns for shareholders over the long term. However, the headwinds noted in my 2017 commentary persisted into 2018, as the market continued to weigh concerns around regulation and the outlook for next generation technologies. In November, the United States Food & Drug Administration (FDA) announced plans to pursue a ban on the sale of menthol products, which caused further weakness across the sector. The portfolio’s holding in BAT was most impacted, given the company’s revenue exposure to menthol sales.

It is my view that the prospect of a total menthol ban remains unlikely, given the requirement to evidence “additional harm” versus non-menthol products. Furthermore, the real impact of a ban remains uncertain, as consumers may move to non-menthol tobacco alternatives. Meanwhile, the tobacco majors are at the forefront of new technologies, with the resources to drive successful innovation in the sector. In 2019 the sector has recovered somewhat, buoyed by the surprise resignation of the Head of the FDA and the release of strong full-year results from BAT, which included meaningful growth in the dividend.

Amid challenging and uncertain market conditions the need to secure diversified income streams for the portfolio remains crucial. The portfolio retains a significant exposure to the final theme of non-correlated financials, which can offer strong cash flow and income generation potential that is not correlated to traditional business cycles. Notable contributors over the period included litigation finance company Burford Capital, which continued to support portfolio returns after posting very strong half and full year results for 2018. In December 2018, the company’s share price was further supported by confirmation that it has secured an additional US$1.6 billion in new litigation investments, whilst full-year results released in March 2019 confirmed a 14% increase in the full-year dividend, a second consecutive year of double-digit growth. The significant underweight position in mainstream banks was a positive decision, as the sector underperformed the overall market, affirming my view of the importance of non-correlated stocks within the portfolio.

Conversely, the portfolio’s holdings in the non-standard lending sector weighed on performance. Amigo performed poorly following its initial public offering last summer as the market became concerned about increased regulatory scrutiny of guarantor-lending. Provident Financial (PFG) also traded down over the period; a result of the slower than expected pace of profit recovery under the new management team. The non-standard lending sector has historically been a strong contributor to portfolio returns and it remains my view that the sector plays an important role in the lending market, providing a competitively priced alternative to borrowers who would otherwise be excluded from access to traditional credit. Furthermore, Amigo and PFG, as regulated entities, are well placed within the industry to respond to an evolving regulatory environment. In February 2019 PFG received an unsolicited takeover bid from Non-Standard Finance, a smaller rival, which saw further volatility in the company’s share price as PFG publicly sought to resist the hostile takeover. The offer has now lapsed.

Elsewhere in the financials sector, a recently initiated position in the financial trading platform Plus500 proved volatile. The company has met with challenges in clearly explaining to the market the short term revenue volatility that can arise in trading of contracts-for-difference (derivative instruments).

Having maintained a zero weighting in mainstream banks for a number of years, a significant new investment was made in Royal Bank of Scotland (RBS). The newly initiated position reflects the portfolio manager’s confidence that RBS is the best capitalised of all UK banks, with the clearest line of sight to delivering substantially improved total shareholder returns. New investments were also made in Cranswick, Draper Esprit, Whitbread, Plus500, Amigo and Urban Exposure. The holdings in AstraZeneca and RELX were sold.

EDIN : Edinburgh board sticking by Mark Barnett

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