Capital Gearing (CGT) has published its annual results for the year ended 31 March 2023, which its chairman, Jean Matterson, describes as a difficult year for the trust and traded markets generally (however, she notes that it is only the second year in the last 41 years, when CGT has failed to achieve a positive return). During the year, CGT provided an NAV total return of -3.6% and a share price total return of -7.1%. The lower share price performance reflects the fact that the shares moved from a modest premium to a small discount to the NAV, ending the year at 4,730p per share [QD comment: in the absence of its discount control policy, which can be commended for its effectiveness, the trust might be trading on a wider discount today].
One of CGT’s key objectives is to preserve shareholders’ wealth by limiting the downside from the portfolio and, in a year with a synchronised bond and equity bear market, a portfolio loss of 3.6% seems reasonable. CGT also aims to grow shareholders’ real wealth over time, and even after a disappointing year, the compound portfolio return over the last five years has been 5.7%, which the chair comments is in line with inflation. [QD Comment: although it has done a decent job of preserving downside during the current bear market, shareholders who have been attracted by CGT’s ability to provide real returns may well be disappointed that it has failed to achieve this at a time that inflation has taken off. It seems that considerable upside has been forgone previously to achieve this result and providing returns that have matched inflation over the last five years might feel a little lacklustre for shareholders, which would certainly explain the move to a discount.]
A cautious approach
CGT’s managers have held a low percentage in risk assets, whilst retaining a high proportion in index-linked gilts and corporate bonds, as well as UK short-dated treasuries. The corporate bond portion was successfully reduced before the latest banking crisis in the US and Europe. Risk assets accounted for just 26% of the portfolio at 31 March 2023. Property investments were reduced as the year progressed, but rising interest rates and substantial discounts emerging across the property sector midway through the year resulted in negative returns, which did little to help CGT’s performance.
In contrast, the corporate bond portfolio made a positive contribution, which far exceeded bond market returns. Index-linked gilts also performed well. As the year progressed, the managers reduced US TIPS in favour of UK index-linked (I/L) gilts. At 31 March 2023, 21% of the portfolio was invested in UK I/L gilts with an average duration of 4 years, and 20% in US TIPS with a duration of 9½ years, reflecting the value that each represents.
Earnings and dividends
With increased bond exposure and higher interest rates, CGT’s income account has been strong this year. The revenue return per share, after tax and expenses, for the financial year was 70.67p, an increase of 24.4% on last year. The company currently pays out one dividend per year, which is proposed as 60p per share. It will be payable on 10 July 2023 for those on the share register as at 2 June 2023, subject to approval at the forthcoming AGM. It should be noted that CGT’s portfolio is not managed with any income criteria, or distribution level, in mind. What the company receives in dividends and interest is the outcome of the application of the investment policy, and the distribution to shareholders is in line with meeting the income distribution test to maintain investment trust status. However, the chairman comments that, given the bond component of the portfolio and the significant increase in bond income being projected, the income may be higher again next year.
Performance comparison review
CGT does not have a formal benchmark, but over the years it has compared its performance over the medium to longer term against two principal measures, RPI and the MSCI UK Index. Following some feedback from shareholders, the board has commenced a review of these performance comparators. For example, RPI is increasingly being replaced by the Consumer Price Index (CPI) as a measure of inflation. Dependent on the outcome of that review, changes to the current performance comparators may be made during the coming year.
Ongoing charges on a declining trend
Ongoing charges as a percentage of its NAV have fallen substantially. CGT’s ongoing charges ratio (OCR) is reported in two ways. The OCR measured solely on the costs of running the company has reduced from 0.52% last year to 0.46% this year. As disclosed in the Key Information Document (KID), when the management costs of the underlying funds into which the company invests are also taken into account, the OCR has fallen from 0.78% last year to 0.64% this year.
Discount control
CGT has a discount control policy (DCP) that provides liquidity to both buyers and sellers in the market at around NAV. Issuing at a premium and buying back at a discount under the DCP more than compensates for its operational costs and is modestly accretive to NAV. Activity under the DCP added 0.5% to shareholder total returns over the last financial year.
Up to December 2022, the company issued 5,688,288 shares raising some £288m, but more recently the company has bought back around 321,500 shares at a cost of £15m, resulting in net issuance of 5,366,788, with a net value of £272m for the year, after costs.
Outlook
CGT’s chairman comments that there is a sense that the interest rate cycle is returning to normal, after more than a decade of virtually zero rates. The recent rise in rates has failed to quell inflation, which has led to large wage rise demands as people struggle to offset the increase in the cost of living. The manager believes that the headline inflation rate will subside in the near term, assisted by anniversary effects. They believe however, that inflation will remain persistent as wage demands continue to build until the unemployment level rises materially. The manager thinks that the policy response from governments and central banks has been somewhat confused, with tighter policy affecting real incomes, but fiscal policy remaining stimulative. This makes economic growth difficult to predict and it is considered likely that there will be a recession at some point. As the stock of government debt continues to grow, public debt to GDP has fallen slightly, aided by the elevated levels of inflation that the economy has experienced over the past year. Markets remain fragile and unpredictable. History suggests that, in times of low interest rates, the misallocation of capital becomes prevalent. It may take a while before this becomes apparent, but we welcome the return to a more rational interest rate environment. The recent demise of Silicon Valley Bank (SVB) has exposed banks’ tier one capital as being less robust after their assets are marked to market on the back of higher interest rates. The managers believe that there is some value emerging in markets, but it is someway off a really attractive entry level and so the manager remains cautious and is retaining a defensive stance until the outlook becomes clearer, and value is noticeably more attractive.
Investment manager’s review of the year
“Your Company delivered a NAV total return of -3.6% for the year, the worst result in the 41 years since we began managing it and only the second time that the Company has had a negative return. Clearly it has been a disappointing period.
“The year was characterised by surging inflation and surging interest rates. The inflation was the all too predictable result of monetary and fiscal authorities’ response to the Covid pandemic: huge expansion of the monetary supply and large scale fiscal support (in particular, direct transfers to consumers). These actions to stimulate demand were set against constrained supply of goods and services, due to disrupted supply chains and a service economy that had been put into suspended animation for the duration of the pandemic. This inflationary dynamic was made very much worse by Russia’s invasion of Ukraine.
“It is hard to overstate the significance of the change in interest rates. No part of our portfolio was untouched. At the start of the year the Company’s UK treasury bill portfolio yielded 0.5%, at the end it was 4.2%. Similarly, the credit portfolio rose in yield from 2.3% to 6.2% and the US TIPS portfolio from -0.9% to 1.4%. Rising yields means falling prices and this created a headwind for the portfolio. In that context it was satisfying that the bond portfolio delivered positive returns during the year especially when compared, as the Chairman notes in her report, to the returns from the sterling aggregate bond index of -15%. We believe that central banks are close to the end of the rate hiking cycle and so what has been a headwind to performance will become, at a minimum, neutral and perhaps an outright tailwind. In the meantime, the portfolio enjoys much higher running yields.
“The repricing of government bonds was most dramatic in the UK, culminating in the debacle of the brief Truss/ Kwarteng administration. As better values emerged we doubled the exposure to UK index-linked gilts, increasing the overall exposure to index-linked bonds from 35% at the start of the year to 46% at the end.
“Ironically, it has been outside our bond holdings that the effect of the change in interest rates has been most acute. In recent years, confronted with a sterling government bond market which we judged uninvestable, we replaced it with a modest allocation to alternatives (property, infrastructure, etc.) judging that their high spreads to government bonds, combined with the index-linked nature of their cashflows, would deliver satisfactory returns even in a rising rate environment. We got this wrong. Indeed losses from our property holdings were responsible for the entire loss the Company experienced in the year. In response, the Company’s weighting to property was reduced from 16.5% to 4% by year end. We judge the prospective returns from the remaining holdings to be excellent, if volatile.
“Outside of alternatives, our equities performed well returning 6% over the year with particularly strong performances from our overweights to the UK (15% return), Japan (6%) and Energy stocks (10%). Our allocation to renewable infrastructure was helpful, returning 7% over the year, and would have been higher were it not for the UK government’s capricious and misguided windfall tax.
“Currency movements in the year were generally favourable with Sterling depreciating against the Euro and US Dollar. During the brief Truss administration, Sterling fell precipitously and we took the opportunity to sell Dollars. With hindsight we should have sold more. Over the course of the year, we increased the Company’s exposure to the Japanese Yen to around 9% across equities, Japanese index-linked bonds and treasury bills. The Yen is extraordinarily cheap compared to the US Dollar and could prove to be a valuable safe haven. In light of Sterling’s depreciation the overall exposure to overseas currencies reduced slightly during the year to around 48%.”