The recent annual results from CT UK High Income (CHI) and Edinburgh Investment Trust (EDIN) have given us the interesting opportunity to compare the views of two managers targeting the UK equity income sector. Since the pandemic lows reached towards the end of 2020, the two funds have seen a wide divergence in performance with EDIN streaking ahead of the UK benchmark with a total return of 74%. CHI meanwhile has struggled, underperforming the benchmark and trailing EDIN by a whopping 45 percentage points.
Energy – a differentiating factor
There are some similarities across the funds, with both holding large positions in financials and consumer discretionary stocks, however one of the major drivers of CHI’s underperformance is the exposure to energy. CHI’s managers have bet actively against the energy sector, holding no exposure in the portfolio despite a benchmark weighting of 12%.
One approach to building a portfolio is to begin with a market neutral position at the sector level (one that mirrors the benchmark), up-weighting areas that the manager is more positive on and down-weighting those that the manager feels less comfortable with.
While neither CHI nor EDIN set out to track indices, taking such a substantial underweight or overweight is inherently risky for a fund’s relative performance, and CHI has clearly paid the price for this, with share price performance ranking towards the bottom of its peer group over the last three and five years.
Why underweight energy – a manager’s view?
CHI portfolio’s underweight to oil was addressed by the managers in the trust’s latest annual report, with the decision entirely driven by their view on quality, returns, and sustainable competitive advantage which they believe are not met by the sector. While the managers acknowledge that the decision has been a ‘sustained challenge’, they believe that when the market rotates towards a ‘risk-on’ mindset, these assets will underperform.
An alternative perspective…
EDIN, by comparison, has taken the opposite route. The company’s largest holding is Shell, which makes up 7.3% of the portfolio. However, EDIN also gains additional exposure to energy markets through Centrica and BP – which was a recent addition to the portfolio – as well as through a number of holdings in other industrial companies. While some of these businesses have struggled so far in 2023, the energy sector has been one of the few bright sparks for investors since the onset of the pandemic, with Shell alone achieving an average annualised return of almost 40% from 2021 to 2023. Temple Bar (TMPL), which ranks just ahead of EDIN, is another trust in the UK equity income space which has outperformed on the back of energy markets over the past few years. The company has taken an even more aggressive approach with almost 20% of the portfolio invested in oil and gas.
Avoid or influence?
Many investors have adopted an anti-fossil fuel stance in the face of the need to tackle climate change and have been urged to use their financial muscle to nudge these companies in the right direction. Some managers have ruled out holding oil majors altogether. Others suggest that the right approach is to hold stakes in these companies but put pressure on them to accelerate the shift towards renewable energy. The latter stance seemed to be gaining traction but there has been some push back. In February, BP upset many by reneging on decarbonisation targets set in 2020. Then, earlier this month, the Net-Zero Insurance Alliance seemed to disintegrate in the face of threats of US litigation.
Unforeseen events?
It is easy to judge the positioning of the CHI trust in hindsight, and no one could have predicted the unfortunate events which have boosted the returns of energy companies over the past couple of years. However, even absent the Ukrainian crisis, the set up in global energy markets appears to be significantly weighted toward the upside, increasing the risks of further underperformance for CHI.
Despite the admirable and rapidly developing renewable transition, the reality is that the global economy remains overwhelmingly reliant on burning fossil fuels for energy. All the while demand for energy, which is closely linked to GDP, continues to grow. Demand for energy is expected to at least double in the next 25 to 30 years and, despite the massive advances in renewable technology and the resulting reduction in costs, the collective contributions of solar, wind hydro and other sources of renewables have so far had only a modest impact on global power production. The UK is one of the countries that has made significant progress (coal accounted for 43% of generation in 2012 versus just 1.5% in 2022) but, for the world as a whole, fossil fuel’s share of electrical power generation has hovered between 60% and 70% for half a century (and it remains higher today than it did in the 1940s).
There may be trouble ahead…
Renewable capacity and technological capability will continue to advance; however, consensus expectations are for oil demand to grow, not fall over the next decade. At the same time, oil majors have shifted their focus to shareholder returns rather than investment in new production, further reducing supply (a common feature of natural resources is that they require a significant amount of capex just to maintain existing supply as reserves are depleted). With the depletion of existing producing resources and damage done to the industry by the whipsaw in demand during the pandemic, there now exists a very real possibility of structural shortages in oil supply that cannot be effectively replaced by renewable assets. This could lead to structural shortages in total global energy supply and keep prices higher than they might otherwise have been.
ESG and other challenges for traditional energy
Of course, it is possible that continued regulation, taxation, and capital flows based on things like environmental concerns could weigh on the returns from traditional energy assets. However, without more aggressive action by governments, these factors are likely years away from having a significant impact on company bottom lines. The current situation appears to be a more extreme version of the decline of the tobacco industry which began around the turn of the century, where the gradual phase out and regulation of the industry resulted in a long term windfall for the incumbents.
Over the next decade or so, this led to generational outperformance for companies like British American Tobacco (which somewhat ironically is the largest holding in the CHI portfolio). In this case, the tobacco industry made up only a relatively small fraction of global market indices, so the risks of not holding the sector were relatively limited. That is not the case for oil.
A balancing act
A crucial part of portfolio construction (and risk oversight) for managers is ensuring that their investment decisions do lot leave portfolios over exposed if prices move in the opposite direction, particularly for funds whose performance is tracked against broad market indices. In many cases, this means that even if conviction is relatively high for a certain investment, the downside must be managed, generally by holding size. Of course, funds must take composition risks in order to generate alpha, however with regards to oil, it seems like the risks of being underweight the sector are considerable going forward. Shareholders must make a choice. Fortunately the investment companies industry has a spread of funds with different approaches to this problem to choose from.