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BlackRock Sustainable American Income hit by a combination of headwinds

230127 BRSA Headwind

BlackRock Sustainable American Income (BRSA) has published its annual results for the year ended 31 October 2022. During the period, BRSA provided NAV and share price total returns of 7.4% and 3.6% respectively, thereby underperforming its reference index , the Russell 1000 Value Index, which BRSA says provided a total return of 10.7% over the period. BRSA says that September and October 2022 were two of the toughest months for the trust since it changed its strategy at the end of July 2021, as the value style underperformed and the trust faced a combination of headwinds including the outperformance of uninvestable sectors (such as aerospace, defence and tobacco), portfolio gearing and poor sector allocation and stock selection in medical technology, consumer discretionary and financials. BRSA comments that the wider market, as measured by the S&P 500 Index, reached bear market territory in mid-June (a drop of 20% or more from a previous peak) and then finished the year to 31 October 2022 down by 1.7% in Sterling terms. There has been a little bit of respite since the year end – as at the close of business on 23 January 2023, BRSA’s NAV had increased by 0.7% compared to a decrease of 1.4% in the reference index (both in Sterling terms with dividends reinvested) since the year end.

Revenue earnings and dividends

BRSA’s revenue earnings per share (EPS), based on the weighted average number of shares in issue for the year, amounted to 3.84p (2021: 4.06p), a decrease of 5.4%. Previously, BRSA had written options and earned premia for doing so (which is treated as revenue income in the accounts) but, following its strategy change, it stopped writing option contracts from 31 July 2021, which has had a negative impact on overall revenue income. However, if option writing income earned in the prior year is excluded, BRSA’s revenue EPS has increased on a like-to-like basis by 29.7%. Four quarterly interim dividends of 2.00p per share were paid on 29 April 2022, 1 July 2022, 3 October 2022 and 3 January 2023. This is in line with the payments made in the previous financial year. The dividend paid represents a yield of 4.1% on the share price at the year end. It has been funded through both revenue and other distributable reserves.

Performance overview

The largest contributor to relative performance was stock selection and allocation decisions in communication services. Within the sector, an underweight to the media industry and the manager’s decision not to invest in the interactive media & services industry accounted for the majority of relative outperformance. In energy, investment decisions in the oil, gas, & consumable fuels industry boosted relative returns. Furthermore, BRSA’s allocation to  utilities proved beneficial due to stock selection and an overweight allocation to the multi-utilities industry.

On the negative side, the largest detractor from relative performance was stock selection and allocation decisions in consumer discretionary. Stock selection within the sector accounted for the majority of underperformance, although allocation decisions in the household durables industry proved costly as well. In financials, stock selection within the insurance industry proved detrimental, as did the manager’s decision not to invest in diversified financial services companies. Other modest detractors from relative results included stock selection within health care, mainly in the health care equipment & supplies and pharmaceuticals industries.

Manager’s comments on BRSA’s individual sectors allocations

Allocations are in Sterling at the end of the period.

Information Technology (IT): 5.3% overweight (13.9% of the portfolio)

“An increasing number of companies in the technology sector are what we refer to as “industrial tech”. These firms are competitively insulated from disruptors, well-positioned to take advantage of long-term secular tailwinds and exhibit growth in earnings and Free Cash Flow (FCF). Strong earnings growth and FCF generation is also translating to an increasing number of companies paying growing dividends to shareholders. This is in stark contrast to the dot-com era where growth was often prioritised over shareholder return. We believe this trend is poised to continue. Our preferred exposures in the sector include IT services and communications equipment companies with sticky revenue streams such as Cisco Systems (2.8% of the portfolio), Cognizant Technology Solutions (2.6% of the portfolio), and Fidelity National Information Services (2.1% of the portfolio). We also continue to invest in software companies with capital-light business models such as Microsoft (1.9% of the portfolio). IT broadly scores well on Environmental, Social and Governance (ESG) metrics given the generally lower environmental impact than other sectors, with our selection of companies including a mix of ESG leaders (Microsoft and Cisco Systems) and ESG improvers (Fidelity National Information Services).”

Consumer Discretionary: 3.9% overweight (10.0% of the portfolio)

“Within the sector, our preferred areas of investment include household durables, textiles and apparel, and firms with auto-related exposure. Disruption risks persist in the sector, and we believe these risks are best mitigated through identifying stock-specific investment opportunities that either trade at discounted valuations or have business models that are somewhat insulated from disruptive pressures. For example, we believe companies such as General Motors (autos; 2.3% of the portfolio) and Ralph Lauren (apparel; 2.2% of the portfolio) offer investors exposure to underappreciated franchises at discounted valuations. Furthermore, retailers such as Dollar Tree (dollar store; 1.8% of the portfolio) provide us with access to businesses that can potentially compound earnings and are more immune to disruptive forces. From a sustainability standpoint, our selection of companies includes a mix of ESG leaders such as Panasonic (1.7% of the portfolio), as well as ESG improvers with clear roadmaps for better ESG adherence and disclosures (i.e. General Motors’ commitment to electric vehicles and Ralph Lauren’s Global Citizen initiative).”

Financials: 1.6% overweight (21.9% of the portfolio)

“Financials represent our portfolio’s largest absolute sector allocation and we remain particularly bullish on companies in the banks, insurance, and wealth management industries. The U.S. banks offer investors a combination of strong balance sheets (their capital levels are meaningfully higher post financial crisis), attractive valuations, and the potential for relative upside versus the broader market from inflation and higher interest rates. We believe the current credit cycle is in its early stages as loan growth is starting to pick up and consumer balance sheets remain quite healthy. In our view this setup could result in upside surprise versus consensus expectations on both growth and credit expectations over the next several years. Secondly, we continue to like insurers and insurance brokers as these companies operate relatively stable businesses and trade at attractive valuations. We categorise most of our holdings in this sector as ESG improvers, with opportunities for company managements to enact stronger corporate governance and human capital development policies. Lastly, we have also identified stock specific investments in wealth management as companies such as Morgan Stanley (1.4% of the portfolio) and Charles Schwab (1.2% of the portfolio) stand out from peers due to their differentiated investment platforms, proximity to end customers and runways for long-term growth.”

Materials: 0.2% overweight (4.3% of the portfolio)

“Our exposure to the materials sector is stock specific. In the metals & mining industry we have a single position in Newmont (1.3% of the portfolio), an advantaged gold miner that operates on the lower end of the cost curve and we view as an ESG leader. We sold our position in Steel Dynamics, the fifth largest U.S. steel producer, in August 2022 based on valuation. Meanwhile, Newmont stands above its gold mining peers due to its strong governance, safety record and environmental management commitments. Within the containers & packaging industry, we have a position in Sealed Air (1.6% of the portfolio), a manufacturer of film packaging for perishable food and industrials/e-commerce. Sealed Air operates a high return business, has good pricing power and in our view offers a relatively stable growth outlook. From a sustainability standpoint, plastic packagers generally score poorly on waste and water stress. The key issue for plastic is how to improve circularity and management has pledged to have 100% recyclable/reusable solutions and 50% average recycled/renewable content by 2025, which is well ahead of peers.”

Health Care: 3.4% overweight (20.4% of the portfolio)

“Secular growth opportunities in health care are a byproduct of demographic trends. Older populations spend more on health care than younger populations. In the United States, a combination of greater demand for health care services and rising costs facilitates a need for increased efficiency within the health care ecosystem. We believe innovation and strong cost control can work together to address this need and companies that can contribute to this outcome may be poised to benefit. On the innovation front, we are finding opportunities in pharmaceuticals and among companies in the health care equipment & supplies industry. We prefer to invest in pharma companies with a proven ability to generate high research & development productivity versus those that focus on one or two key drugs and rely upon raising their prices to drive growth. Outside of pharma, our search for attractively priced innovators is more stock specific; we recently initiated a position in Baxter International (1.9% of the portfolio) a health care company focused on products to treat kidney disease and other chronic medical conditions. We believe the company is poised to do well as margin pressures from temporary inflation (logistics and shipping) suppress and the economy continues to reopen. From a cost perspective, health maintenance organisations (HMOs) have an economic incentive to drive down costs as they provide health insurance coverage to constituents. These efforts ultimately help to make health care insurance affordable to more people and the HMOs also play a substantial role in improving the access to and quality of health care its members receive. Fundamentally, we believe our holdings in the sector can benefit from downward pressure on cost-trend, new membership growth and further industry consolidation over time. Furthermore, they trade at meaningfully discounted valuations versus peers, offering us an attractive risk versus reward opportunity.”

Energy: 0.1% underweight (8.7% of the portfolio)

“The portfolio currently invests in five energy stocks and we have a neutral weight in the sector relative to the reference index. Our focus on sustainability places a high hurdle for energy companies to be included in the portfolio, but we believe the sector remains investable, as more traditional oil & gas operators are critical in the energy transition towards less carbon intensive sources. For example, natural gas is 40-60% less carbon-intensive to produce and combust versus coal and oil. We view natural gas as a key “bridge fuel” and like companies such as Woodside Energy Group (2.0% of the portfolio) and EQT (1.3% of the portfolio). Fundamentally, we generally seek to invest in attractively priced operators with good resource assets that have the opportunity to improve upon environmental issues or demonstrate clear leadership in sustainability (i.e. through their exposure to renewables or commitments to net zero/carbon neutral outcomes). We also prefer to target companies with experienced management teams, low financial leverage and disciplined capital expenditure spending plans, as these elements can contribute to positive free cash flow generation over time.”

Utilities: 1.4% underweight (4.2% of the portfolio)

“The portfolio currently invests in only two utility stocks and we have a slight underweight in the sector relative to the reference index. Portfolio exposures are stock specific as we are finding pockets of investment opportunity among U.S. regulated utilities, which add a level of stability and defensiveness to the portfolio through their durable earnings and dividend profiles. Our investments in the sector primarily focus on ESG leaders that have specific targets for reduction in carbon emissions and maintain significant exposure to renewables or generate power through cleaner means such as natural gas.”

Communication Services: 2.9% underweight (4.4% of the portfolio)

“The portfolio has an underweight to communication services. Our underweight is driven by expensive valuations and a lack of dividend payers in the entertainment and interactive media & services industries. Meanwhile, the portfolio is overweight to the diversified telecom services and wireless telecom services industries. Notable portfolio holdings include Verizon Communications (diversified telecom; 2.8% of the portfolio) and Rogers Communications (wireless telecom; 1.6% of the portfolio). Verizon Communications and Rogers Communications trade at reasonable valuations, boast strong competitive positions and rank well on ESG metrics versus peers. We also like that their core businesses, operating telecom networks, can be a key enabler of smart cities of the future, with potential to reduce energy consumption and provide other social benefits.”

Consumer Staples: 1.9% underweight (5.4% of the portfolio)

“The consumer staples sector is a common destination for the conservative equity income investor. Historically, many of these companies have offered investors recognisable brands, diverse revenue streams, exposure to growing end markets and the ability to garner pricing power. These characteristics, in turn, have translated into strong and often stable free cash flow and growing dividends for shareholders. In recent years, some of these secular advantages have become challenged, in our view, due to changing consumer preferences, greater end market competition from local brands and disruption from the rapid adoption of online shopping. These challenges, combined with higher than historical valuations, have facilitated our underweight positioning in the sector. Notable portfolio holdings include PepsiCo (2.6% of the portfolio). We held Lamb Weston Holdings during the year and exited the position before the year end. We view each of these businesses as ESG leaders: PepsiCo stands out for reducing its water usage and product carbon footprint and Lamb Weston is at the forefront of implementing strong corporate governance practices.”

Real Estate: 3.2% underweight (1.3% of the portfolio)

“The portfolio has an underweight allocation to real estate, as we are finding few companies in the sector with both attractive valuations and strong or improving fundamentals. For example, retail REITs are facing challenges due to e-commerce and its negative impact on traditional brick and mortar retailers. Meanwhile, data center and logistics companies have strong fundamentals, but we view their valuations as unattractive. Our only portfolio holding is CBRE Group (1.3% of the portfolio), the world’s largest commercial real estate services firm. The company is trading at a wide discount relative to peers and ranks well on ESG metrics versus peers. CBRE Group signed the Climate Pledge in 2021 to reach net zero by 2040.”

Industrials: 4.9% underweight (5.5% of the portfolio)

“The portfolio is meaningfully underweight to the industrials sector. Our selectivity is driven by relative valuations, which we view as expensive, in many cases, versus other cyclical value segments of the U.S. equity market. Notable positions include Komatsu (1.9% of the portfolio), a Japanese manufacturer of construction and mining equipment, and Norfolk Southern (1.7% of the portfolio), a major U.S. east coast railroad operator. We view both companies as ESG leaders in their respective domains. Komatsu has set meaningful targets for reduced CO2 emissions from its products by 2030 and to achieve carbon neutrality by 2050. Furthermore, Norfolk Southern provides us with exposure to a consolidated industry with pricing power that emits roughly one-third as much CO2 as trucks (the main shipping alternative), in moving an equivalent amount of cargo.”

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