Acorn Income (AIF), the UK-focused small-cap equity and fixed-income trust, released its annual performance figures today. Over the year to 31 December 2019, AIF delivere a total return on gross assets, which measures the return on the portfolio including all income and costs, amounted to 19.2%, while the total return on net assets, enhanced by the gearing effect of AIF’s zero dividend preference (ZDP) shares, increased by 27.4%. By comparison, AIF says that total return from the Numis smaller companies (ex-Investment Companies) index, came to 25.2%.
The goal posts have of course shifted drastically since 2019. Over March, the gearing within split-capital trusts like AIF, magnified the NAV impact felt from covid-19 related selling.
Below, we include outlook extracts from the manager reports accompanying the annual results.
Outlook from the smaller companies managers
Simon Moon and Fraser Mackersie, the smaller companies managers, commented: “Looking to the prospects for 2020 the focus must unfortunately rest on one severe and ongoing event: the covid-19 pandemic. The covid-19 graduated from being a ‘Chinese problem’ in January that seemed to little bother the rest of the world, to a panic-inducing worldwide phenomenon by March. As the virus rapidly spread from the East to the West, governments and public health services rushed to coordinate their responses to the threat with varying degrees of severity and success. In an effort to contain the spread of the virus the UK Government followed the lead taken by most European countries and imposed a lockdown on its population and, by extension, a large proportion of economic activity. A similar approach is also now being taken in the US in an attempt to contain the outbreak, which will inevitably place further pressure on the global economy.
The speed of the contagion was matched by the rapidity of the sell-off across equity markets as investors sought to reduce risk in the face of uncertainty, as such markets suffered extreme falls and dramatically increased volatility. The UK Government has worked in lock-step with the Bank of England to provide a coordinated response to the threat posed by both the virus and the lockdown that will far exceed the UK’s response to the global financial crisis. Although obviously expensive the ultimate aim of this huge economic stimulus is to keep people in jobs and ensure that companies are ‘ready to go’ when the crisis passes. We believe these measures should position the UK relatively well for the recovery. Regardless of how resilient or otherwise the UK is over this period the key unknown element is the length of time it will take to get the virus under control as that will be the pathway to a recovery in economic activity.
During such an exceptionally volatile and uncertain period for equity investors we have taken a number of steps to de-risk the portfolio – from both a balance sheet and end market perspective. We entered the period under review with low levels of debt across the portfolio. Where we have identified higher levels of risk in the portfolio we have taken decisive action to improve this position further. While a number of our investee companies are currently experiencing disruption to trading we believe our strong starting point and subsequent actions leaves the remaining investee companies well placed to survive a prolonged period of lower activity.
The company is therefore invested in a portfolio of well-financed companies that address robust end markets; action taken by the Advisers has reduced end market and balance sheet risk even further whilst increasing cash levels at the same time, cumulatively this has improved the ability of the portfolio to weather this storm. Although it is currently and will likely continue to be a testing time, volatility provides opportunities and our cash balances are high so we can quickly deploy capital. We need to be perceptive and mindful of when this crisis starts to turn and as such our attention is focused on any indications that the virus is under control. Evidence of the control of the virus is, in our opinion, a better signal of a nascent economic recovery than any announcement of fiscal stimulus.
In order to assess the risks in the current portfolio our analysis has focused on dividing the holdings into three main groups – Continuity, Resilience and Recovery. This analysis has also framed our income expectations for the current year. Companies in the Continuity group continue to trade reasonably well and we do not currently envisage any significant change to forecasted dividend payments. The Resilience group includes those businesses that are continuing to operate but have suffered disruption in the current environment. Whilst dividend payments should continue from this group more modest payments are likely. The final group is Recovery, where companies are experiencing a more pronounced impact on current trading but have the capacity to participate strongly in any recovery. We view dividend payments as unlikely from this group in the near term but also view them as likely to resume quickly. Roughly half of the portfolio is in the Recovery group, with the balance fairly evenly split between Continuity and Resilience. These groupings and assumptions have formed the basis for our dividend income stress testing in the current year.”
Outlook from the income managers
Chun Lee and Robin Willis, managers of the income portfolio, said: “Whilst there has been no sector left unharmed by the sell-off, we are relatively comfortable with the largest sector exposure within our corporate bond holdings, especially national champion banks. Whilst in the last crisis, the banking system was at the heart of the problem, now it is seen as a vital part of the solution as central banks have moved swiftly to ensure lenders have the tools to continue supporting the economy. Whilst it was politically difficult to help the financial sector out of a problem of its own making in the last crisis, the current exogenous shock should ensure that domestic and globally important banks are supported by governments to ensure that the transmission mechanisms of its policies operate smoothly. In addition, the key banks now have a much greater loss absorbing capacity and have been run more conservatively than before, driven by a strict regulatory overhaul.
Outside of financials, exposures are predominantly to less cyclical areas which should prove more defensive and less disrupted in the current environment. Whilst not without their own challenges the likes of domestic supermarkets and telecommunications should prove to have more resilient characteristics, continuing to be essential services during the lockdown. Meanwhile corporate bond exposure to companies within highly disrupted sectors such as commercial transport is relatively limited and to issuers which are a crucial parts of the UK’s infrastructure and have decent access to liquidity for now, and should be beneficiaries of the government’s announced support packages for affected key industries.
Despite unattractively low real yields, Sovereign bonds have offered multi-asset investors some welcome diversification during these risk-off periods although there have been times where even this traditionally low risk volatility asset class has seen wild swings in price movements.
The portfolio has benefitted from its exposure to Gilts and U.S Treasuries, however as government bond yields get ever lower so do their ability to offer protection, unless highly negative yields across the world become a reality. Another consideration must also be the large prospective sovereign bond issuance and budget deficits needed to fund emergency stimulus. If they prove to be successful, then yields in longer dated bonds may well start rapidly to price in these risks, coupled with the prospect of a renewed rise in inflation, unlikely as both may seem at present.
In order both to diversify risk away from bond markets and to supplement income generated, the portfolio has invested in a number of alternative investments. Positions in investment companies that invest in alternative asset classes, such as music royalties and energy efficiency projects, have provided diversification benefits and although in the current sell-off nothing has proved to be immune, our expectation is that some of these investments will be supported by their unique exposures, discounts to net asset value and income generation characteristics.
As risk assets cheapen, valuations have undoubtedly become more attractive within select opportunities, some of which will prove to be resilient through a downturn whilst others will bounce back strongly should the economic effects not be as severe as feared. Importantly, freshly announced measures by global central banks to support credit markets are showing signs of easing the initial dysfunction. However at this juncture it is perhaps prudent to be patient and assess how the spread and disruption of the pandemic evolves and changes the potential for defaults, when attempting to establish where to hunt for value. In the meantime, we will continue to prioritise preserving capital and having some cash available will provide important optionality when visibility improves.”
AIF: Acorn Income discusses its outlook