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New Star hindered by low allocations to US and large cap UK

New Star (NSI) has announced its annual results for the year ended 30th June 2022, during which it provided an NAV total return of 9.53%, leaving the NAV per ordinary share at 174.56p. By comparison, the Investment Association’s Mixed Investment 40-85% Shares Index fell 7.12%. The MSCI AC World Total Return Index fell 3.73% in sterling while the MSCI UK Total Return Index rose 3.16%. Over the year, UK government bonds declined 14.27%. In falling markets, NSI benefited from a high allocation to sterling cash and US dollars. However, the trust’s investments in technology stocks and a relatively low allocation to both US equities and large-cap UK equities hurt performance.

Investment manager’s review – comments on the market#

“Global equities and bonds fell 3.73% and 3.60% in sterling respectively over the year to 30th June 2022 as rising inflation and interest rates hurt economic growth. Global equities rose 7.86% in sterling in the first half of the year under review as economies emerged from Covid-19 lockdowns and rising inflation was largely dismissed as transitory. Central banks, including the Federal Reserve, turned more hawkish around the New Year, however, as inflation became entrenched. Global equities and bonds fell 10.74% and 3.99% in sterling respectively over the second half of the year under review.

“Russia’s invasion of Ukraine in February 2022 exacerbated the rise in energy and materials prices caused by the synchronised recovery in global demand following the end of Covid-19 lockdowns. The US is close to self-sufficient in energy because it has exploited its shale gas reserves whereas European governments have closed coal-fired and nuclear power stations, leaving the region dependent on Russian gas. In the short term, liquid natural gas can be purchased from the US but it will take time to reduce dependence on Russia by accelerating the transfer to renewable energy and by classifying some gas and nuclear developments as “green investments”.

“In July 2022, headline inflation rates in US, eurozone and UK were 8.5%, 8.9% and 10.1%, far above the central banks’ 2% targets. US inflation fell from a 9.1% high in June and may have reached its cyclical peak but inflation is likely to rise in Europe because of higher energy costs as a result of Russian gas supply restrictions. Before the recent announcement of energy subsidies, the Bank of England said UK inflation might exceed 13% in the fourth quarter of 2022 because of the planned Ofgem energy price increase and other factors. Monetary policy tightened and in September 2022, US and UK official interest rates were 3.00-3.25% and 2.25% respectively. In the eurozone, key policy interest rates rose by half a percentage point in July as the European Central Bank abandoned negative interest rates and by a further 0.75 points in September. UK government bonds, sterling corporate bonds and sterling high-yield bonds fell 14.27%, 14.54% and 11.78% respectively over the year as the widening differential between shorter-dated US and UK interest rates led to sterling weakness and UK economic prospects deteriorated. The pound fell 12.09% against the dollar over the year.”

Investment manager’s review – comments on the portfolio

“Your Company had a negative total return of 9.53% over the year under review. By comparison, the Investment Association Mixed Investment 40-85% Shares sector, a peer group of funds with a multi-asset approach to investing and a typical investment in global equities in the 40-85% range, fell 7.12%. The MSCI AC World Total Return Index fell 3.73% in sterling over the year while the MSCI UK All Cap Total Return Index rose 3.16%. In falling markets, your company benefited from a high allocation to sterling cash and dollars. Investment in technology stocks and a relatively low allocation to US equities and large-cap UK equities, however, hurt performance.

“In January 2022, following a shift towards tighter monetary policies by some central banks, your Company increased cash by approximately £8 million through partial sales of Fundsmith, Crux European Special Situations and Trojan Income and the outright disposal of Aberdeen Standard European Income and Chelsea Managed Monthly Income.

“Your Company also received a net £14.8 million from the sale of a private-equity investment, Embark Group, to Lloyds Banking Group. As a result of this disposal, your Company’s private-equity investments fell from 12% of assets to 2% over the course of the year. Approximately £1 million was invested in Vietnam Enterprise Investments. In March, after falls by US stocks in January and February, $5 million was invested in the iShares Core S&P 500 exchange-traded fund (ETF).

“Tighter monetary policy contributed to a rotation in market leadership in favour of global value stocks, which gained 5.25% in sterling over the year whereas growth stocks fell 12.77%. Growth stocks had made gains during the initial phases of the Covid-19 pandemic because their future cash flows were discounted less aggressively in an environment of near-zero interest rates. Technology stocks had been particularly strong because Covid lockdowns accelerated the adoption of new technologies, fuelling demand for electronic goods and online services. US technology stocks, however, retreated 7.45% in sterling over the year and Polar Capital Technology did worse, falling 21.75% because its holdings in smaller stocks tended to underperform larger peers.

“The underperformance of growth stocks and technology companies in particular also contributed to an 11.13% fall for Fundsmith Equity, whose concentrated portfolio included Meta, the owner of Facebook, as well as Intuit and Paypal. By contrast, Baillie Gifford Global Income Growth fell 2.75% as greater diversification and an income mandate proved defensive.

“Equities in Europe excluding the UK lagged, falling 9.78% in sterling as energy prices, particularly gas prices, rose after Russia’s invasion of Ukraine. European policymakers are being forced to confront the consequences of energy policies that have left the region dependent on Russian gas. BlackRock Continental European Income fell 10.56% while Crux European Special Situations, which has a growth bias and typically has significant holdings in smaller companies, fell 15.27%.

“UK equities rose against the trend because of the UK stockmarket’s bias towards cyclical value sectors such as energy and mining. UK smaller companies, however, underperformed because of their higher sensitivity to domestic trends, falling 17.18%. Within your Company’s portfolio, Man GLG Income, which has a value investment style, did best, rising 0.83%. By contrast, Trojan Income, which typically invests in companies where the earnings sensitivity is lower than the market, fell 6.94%. Chelverton UK Equity Income and Aberforth Split Level Income, two small-company specialists, fell 11.51% and 23.19% respectively. The weakness among UK small companies was magnified in Aberforth Split Level Income’s fall because of portfolio leverage resulting from the trust’s zero dividend preference shares.

“Equities in emerging markets and Asia excluding Japan fell 14.68% and 14.44% respectively in sterling over the year, with Chinese equities, which account for the largest proportion of both indices, down 22.30%. Chinese stocks fell because of weak growth resulting from the country’s “zero-Covid” policy, which led to lockdowns in cities such as Shanghai, an over-indebted property sector and increased political risk stemming from state intervention in quoted companies in accordance with Beijing’s “common prosperity” policy. Matthews Asia ex-Japan Dividend and Liontrust Asia Income fell 9.93% and 8.65% respectively. The JP Morgan investments, Emerging Markets Income Trust and Emerging Markets Income Fund, fell 13.86% and 5.48% respectively. The bias towards regional funds managed in accordance with an income mandate proved defensive as low-yielding big Chinese technology companies such as Tencent and Alibaba fell sharply while higher-yielding stocks such as Taiwan Semiconductor Manufacturing Company fell less.

“Amongst single-country emerging market income investments, Stewart Investors India Sustainability, which aims to buy companies with strong business models and balance sheets, did best, up 9.31% while Indian equities gained 8.70% in sterling. Vietnam Enterprise Investments fell 3.16%. Vietnamese equities are benefiting from monetary discipline, high public sector spending and an expanding middle class. Some global manufacturers have moved capacity from China to benefit from lower costs and avoid Sino-US sanctions. Following Russia’s Ukraine invasion, the HSBC Russia Capped exchange-traded fund suspended trading. Your Company has taken a conservative approach and valued the investment at zero.

“Your Company predominantly invests in equity funds and achieves diversification through holding other assets including cash and currencies, low-risk multi-asset funds, alternative funds and gold equity funds. It has minimal exposure to bonds and no direct investment to UK government bonds which have fallen sharply since your Company’s year-end, forcing the Bank of England to intervene and buy UK government bonds to stabilise the market. Your Company benefited from holding dollars, which represented 12.5% of NAV at the year end, with sterling falling 12.09% against the dollar over the year. Amongst its low-risk multi-asset holdings, Trojan rose 1.47% while EF Brompton Global Conservative fell 6.54%. Aquilus Inflection, an alternative investment, fell 3.11%. Gold rose 15.25% in sterling but gold equities fell 9.87% as margins came under pressure from rising costs. BlackRock Gold & General, which invests in gold producers, fell 10.36%.”

Investment manager’s review – comments on outlook

“In the early autumn of 2022, US inflation remained far above the Federal Reserve 2% target but appeared to be close to its cyclical high, with tighter monetary policies reducing demand and economic activity. In Europe, inflation may rise further because of Russian gas supply restrictions. The US economy was technically in recession following two quarters of economic decline and some leading indicators implied that a further contraction was likely. US 10-year government bond yields close to 3% may present a buying opportunity.

“Equity valuations have fallen but earnings forecasts may be too high as margins come under pressure from higher costs and the impact of rising living costs on consumer spending. The longer-term prospects for equities look positive overall, however, because some companies have the ability to pass on higher inflation through higher prices and reward investors through higher dividends. Equity income investments may outperform because higher yields may support valuations. Your Company’s equity income holdings also contribute to the ability to pay a dividend although investment income has yet to regain pre-Covid-19 levels.

“At the year-end, your Company held 19.79% of its NAV in sterling and dollar cash. Your Company was cautiously positioned prior to Russia’s Ukraine invasion and has taken advantage of weak markets to increase its overall allocation to equities modestly. Further falls in equity markets may present buying opportunities for longer-term investors.”

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