Scottish American (SAIN) has announced its annual results for the year ended 31 December 2021, during which it provided an NAV total return for the year of 21.5%, which was modestly ahead of the total return from global equities of 20.0%, while its share price total return was modestly behind at 19.5%. SAIN says that its returns were assisted by the resilient operational performance of many of its underlying companies, and also by a strong return from its property investments. The full year dividend, including a recommended final dividend of 3.375p, is 12.675p per share. This is 5.6% higher than the 2020 dividend, extending the Company’s record of dividend increases to forty eight consecutive years. The increase is above the rate of UK CPI inflation over the same period, which was 5.4%.
Manager’s comments on the equity portfolio
“The equity portfolio continues to dominate these results, given that it represented on average 94.1% of the Company’s net asset value. Over the course of the year our equity portfolio delivered 21.0%, which was slightly ahead of global equity markets (20.0%). The global economic recovery was in full swing throughout the year, leading to growing bottle-necks in supply chains as companies struggled to respond to a recovery in consumer demand. Stock markets in the US and Europe performed more strongly than those in Asia and Emerging Markets over the course of the year, which partly reflects the recovery in economic confidence in the West, and partly the struggles that some developing countries have had with managing successive waves of the pandemic. However, our performance continued to be driven by the idiosyncratic opportunities at our companies, whether that is insulin maker Novo Nordisk’s success in developing novel treatments for obesity, or Silicon Motion’s success in taking share in the controllers for flash memory storage in the semiconductor industry. In other words, it’s been the success of individual companies’ management teams in executing on their opportunities rather than clever top-down calls that have delivered solid returns over the year – which tends to be how we like it.
“Dividend growth from the equity portfolio across the year was robust, with dividend income growing by 6.5% per share. The majority of our holdings posted healthy dividend growth, as they gained confidence in the robustness of their businesses. In addition, readers may remember that a handful of our holdings reduced dividends in 2020, and most of these rebounded in 2021. On top of these factors, holdings such as Rio Tinto, T. Rowe Price and Admiral delivered not just strong dividend growth but paid large special dividends. Set against that, the strength of sterling against currencies like the US dollar and euro was a headwind to income growth.
“There is, though, another factor which affected our dividend growth, which is less visible from the outside. Our strong belief is that income investors will get the best results if they focus on long-term income, not short-term yield. By this, we mean that we would rather invest in a company where we have real confidence that the dividend will be resilient and the growth strong over five or ten years, than take a chance with a company with a high near-term yield, but where we believe there are serious doubts over either the growth or the sustainability of that income stream. Some people call our approach ‘quality’, but we tend to think of it more as another dimension of being ‘long-term’.
“In practical terms, that means we are constantly challenging our investments, and asking ourselves whether the growth is good enough to justify a place in the portfolio. Where there are names in the portfolio where the attraction leans too much on ‘income today’, and not enough on what that income might be over the next 5 or 10 years, we try to be disciplined about them. Selling a potential income trap, and investing the proceeds in a great growing franchise which pays dividends as it grows, may lead to a slight reduction in this year’s income. But in our experience it has usually been the right thing to do in the long-term, both for the capital growth it enables, and the future income performance of the fund. And it is almost always better for your wealth than the reverse of this process, selling good businesses in order to buy some near-term income from a business whose long-term prospects are poor. This is one reason why in the portfolio diagram on page 12 of the Annual Report and Financial Statements, readers will see comparatively few names on the right-hand side of the income distribution today. Bringing this to life, towards the end of the year we made an investment in Starbucks, the global coffee chain, and sold British American Tobacco (‘BAT’). It is clear to us that the long-term volume growth prospects of Starbucks are likely to be far stronger – the store base could easily grow at mid single digits for a decade, and there is ample room to improve the throughput of their stores (especially developing more ‘drive-thru’ locations). The company has strong values, terrific brand equity, and a record of robust pricing. It is run by people who are thoughtful about its long-term success. It currently pays a dividend yield slightly below 2%, but we are confident that this will grow strongly over the coming decade. BAT’s growth, meanwhile, looks to us increasingly challenged, and we suspect that they will struggle to grow an already high dividend.
“We took holdings in five new companies during the year, including Starbucks. As in recent years, the opportunities were eclectic, and spanned the globe. A common thread is that we are investing in companies we think are likely to be the market leader, and alongside management teams that we rate very highly, and where we expect dividends in five or ten years time to be substantially higher than today. In some cases this is because we expect the markets they serve to grow quickly. For instance, Taiwanese company TCI Bio is a leader in nutritional ingredients, that go into nutritional drinks and skincare products. Unlike their peers, they have invested heavily in research, and the ability to manufacture at scale – and we hope they will replicate their strong position in China in other large markets.
“That ambition is echoed in Midea Group, the first Shanghai-listed company SAINTS has invested in. They have grown into one of the largest air conditioning and home appliance manufacturers in China, with a distinctive direct distribution model. Our Shanghai-based research team view them as one of China’s best-managed companies. Midea have plans to grow their operations overseas, but also apply their skills to industries like robotics and elevators – ambition in action. We expect to find other such opportunities over the coming years. Closer to home, Línea Directa is the leading direct motor insurer in Spain, and enjoys the same large cost advantage over its traditional competitors that Admiral has had in the UK. Like Admiral, we expect them to steadily take share of its market, expand into different types of insurance such as home and health. They have a tremendously cash generative business model which should support dividend growth. Finally, Valmet sells capital equipment and services to the pulp and paper industry. Pulp and paper companies are rarely good businesses, partly because they have to invest enormous amounts in equipment. As Warren Buffett famously found with the textile industry, the benefits of those investments have tended to accrue to their customers, and their suppliers (like Valmet). We think that growth for Valmet will be especially strong over the coming decade, as mill owners are forced to invest to mitigate their impact on the climate and environment more broadly.
“We funded these through sales of China Mobile and Sumitomo Mitsui Trust Holdings, as well as BAT. In each case, we had lower conviction in their being a good fit with our aim of delivering a resilient, growing income stream over the long-term – both because of the capital intensity of the business, and the ambitions of the management team. We also sold our small holding in the Aberforth Split Level Income Trust, a fund which invests in smaller UK dividend-paying companies.”
Manager’s comments on other income-generating assets
“Alongside the equity portfolio, we invest in other income-generating assets, with an aim of delivering a spread above our long-term cost of borrowing. We also expect these holdings to support the resilience of SAINTS’ earnings, because their distributions typically have a relatively low correlation with our equity dividends. During the year we established a small infrastructure equities portfolio as part of this. Our aim here is to find companies which we believe will deliver income and capital growth modestly ahead of inflation. Besides our existing holding in Greencoat UK Wind, we took small holdings in Italian grid operator Terna, Chinese toll-road operator Jiangsu Expressway, medical practice owner Assura, and infrastructure operator BBGI Infrastructure. This allocation delivered £0.9m of income during the year. The average yield of these holdings is over 4%, whereas SAINTS’ average cost of borrowing will this year fall just below 3%.
“The property portfolio delivered a 25.7% total return over the year. Credit for this terrific performance belongs to OLIM Property, who have managed the portfolio since 1996. OLIM’s investment strategy remains focused on identifying long-term inflation-linked leases, backed by good covenants, in less well-trodden parts of the UK property market. The strong returns delivered by SAINTS’ portfolio in 2021 partly reflects a healthy market for UK commercial property in 2020, where values rebounded after a challenging experience in the pandemic: a total return of 16.5% was delivered by the MSCI UK Quarterly Property Index. However, SAINTS’ returns were significantly boosted by the sale of the Data Centre in Milton Keynes that was leased to Talk Talk, which was our largest single investment. The sale price of £23.9m represents a 45.9% premium to its valuation in December 2020, which shows how strong the appetite is for data centres today. This means that this investment has delivered an excellent return of 17.3% per annum since purchase in 2017. The sale of this property meant that rental income for the year was around 10% lower, at £4.9m, but the underlying income performance of our properties was robust, with inflation-linked rental increases across most of our properties. Despite strong capital growth, the sale also meant the property portfolio ended the year at £74.9m, around £10m smaller than at the end of 2020, or 8.1% of the Company’s net assets. In early January 2022, £7.75m of the Milton Keynes proceeds were used to purchase a Premier Inn in Holyhead.
“Our fixed income portfolio delivered a modest positive return of 0.8% over the year. Income of £2.6m was increased over the prior year (£1.1m), partly offset by a 5% capital loss. That loss was the result of growing concerns around inflation, which pushed interest rate expectations higher over the course of the year, as well as the strength of sterling compared to the US dollar and other currencies. The only notable change in our holdings during the year was the purchase of a small number of emerging market sovereign bonds. At year end, fixed income represented 5.3% of net assets, split between corporate bonds, and emerging market sovereign debt.”
Manager’s comments on borrowings – making the most of the new opportunity
“2022 is a water-shed year for SAINTS. The £80m debenture that was taken out in 1997, with a coupon of 8%, will mature; and we will draw down on our new long-term borrowings, with a coupon of 3.12%. When combined with the £15m of additional borrowings we drew down this year, the Company’s effective interest cost will more than halve, to a touch under 3.0%.
“As we describe in the Investment Approach, the potential benefit of SAINTS having some long-term borrowing is that there is an opportunity for us to invest in assets that deliver additional income for shareholders, with a spread above the cost of borrowing, as well as the potential for capital growth. Unfortunately, over recent years the actual benefit of this strategy has been modest, certainly for income, given the high cost of the Company’s borrowing – and it has also required SAINTS to invest in some higher yielding assets. The key one has been the property portfolio, which has delivered terrific returns under OLIM’s stewardship over the last 25 years, and handsomely beaten that cost of borrowing.
“The good news is that with a lower cost of borrowing, the benefit to shareholders of having this borrowing in the capital structure should be greater than it has been in the past, and the opportunity set of investible assets should be broader. The question that we and the Board have discussed at length over the last two years is: what are the best assets to hold against this for the long-term?
“Our initial conclusions are:
- We and the Board continue to believe that the property portfolio remains a good fit for SAINTS’ aim of delivering a resilient income stream that out-paces inflation: 78% of income is either RPI-linked or subject to fixed increases, and it has proven to be impressively resilient through periods of stress.
- We think that some high quality infrastructure assets should share several of these attractive characteristics. Additionally, they should have rather less economic sensitivity than either our equity or property portfolios, which over time should be helpful in delivering a resilient income stream. This is why we have started to build a portfolio of these names with the help of Baillie Gifford’s infrastructure analysts, as detailed above. This initiative is in its early days, and we would hope to uncover some additional interesting opportunities here over the coming years: we have much to learn about the space.
- Fixed income on the other hand doesn’t offer inflation protection, but what it does offer is contractual certainty, and a significant degree of diversification from our other sources of income. Both have value – and again, we benefit from in-house stock-pickers who we think can help us find a small number of the best credits for our aims.
“The right balance between these three broad buckets is something we debate, and will no doubt evolve over time, as will the income streams of income on offer. But we think that careful individual stock selection within these three very broad asset classes should help us ensure that the income stream is meaningfully higher than it would be from a pure equity portfolio – and that the diversification they offer should also make it more resilient.”