Capital Gearing (CGT) has published its annual results for the year ended 31 March 2024, during which it provided an NAV total of 1.8%, which its chairman, Jean Matterson describes as far from satisfactory when compared to the rise in the consumer price index (CPI) of 3.2%. The share price total return over the period was lower at 0.8% as the discount ended the year at a slightly wider margin of 2.4%. However, over both three and five years, the trust has lagged its CPI benchmark by significant margins, particularly over the three-year period.
Matterson goes on to say that the last 12 months proved to be another year of rising interest rates and widening investment trust discounts as well as a period of sterling strength. These factors impeded many defensive investment companies and performance was pedestrian. However, the last two years have been a period of dramatic repricing in the most significant markets in which CGT invests, raising the prospect of improved medium-term returns.
Earnings and dividends
The amount that CGT receives in dividends and interest is an outcome of the trust’s investment policy rather than a target in itself and CGT’s income distribution is largely to ensure that it maintains its investment trust status. Given the significant increase in bond yields, CGT has received appreciably more bond income compared to last year, but this year’s revenue return per share for the year, after tax and expenses, was 69.74p, a decrease of 1.3% on last year. CGT is proposing a dividend for the year ended 31 March 2024 of 78p per share. Subject to approval at the AGM, this will be payable on 5 July 2024 to shareholders on the share register as at 6 June 2024. CGT’s chair says that, if bond income remains high, CGT is likely to consider paying at least part of future dividends as interest distributions. If interest distributions are to be paid, further information will be provided at the relevant time regarding any potential tax consequences for shareholders.
Share issuance and buybacks
CGT has a discount control policy (DCP) that provides liquidity for both buyers and sellers in the market at around NAV. Over the last 12 months, CGT has repurchased 4,220,036 shares for a total of £195m. For a period of approximately three months in the second half of the year, the operation of the DCP was temporarily restricted while the trust sought court approval to cancel its share premium account and create an equivalent distributable reserve. These restrictions were lifted in February 2024, and since then the DCP has been operating normally. CGT’s board says that it remains committed to the DCP and is confident that the issues experienced around availability of distributable reserves will not occur again. At the year end, the share price discount to net asset value per share was 2.4%. CGT’s chair comments that 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 approximately 0.3% to shareholder total returns over the last financial year.
Costs
Over the year, buybacks have reduced the size of the trust putting upward pressure on its ongoing charges ratio (OCR). This is reported in two ways. The OCR measured solely on the costs of running the company has increased from 0.46% to 0.47% 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 risen from 0.64% last year to 0.69% this year.
However, following the outcome of CGT’s supplier review process, its investment management and administration costs will increase slightly. Based on the company’s net asset value as at 31 March 2024, these increased costs are expected to have the effect of increasing the OCR by approximately 0.05%.
Comments from the investment manager
“Your Company delivered a NAV total return of 1.8% for the year, which was an improvement on the previous year but still less than the rate of inflation and therefore not satisfactory.
“We began the year defensively positioned and, as things turned out, were too cautious. Chief among our concerns was that years of ultra-low interest rates had caused a buildup of risk throughout the financial system which would be revealed by higher interest rates and the shrinking money supply. This is hardly a new phenomenon. Writing in 1848, Walter Bagehot put it as follows: “It is a fact of experience, that when the interest of money is two per cent, capital habitually emigrates, or, what is here the same thing, is wasted on foolish speculations, which never yield any adequate return.”
“As it turned out, the spat of bank failures in the spring of 2023 were contained with little spillover into other markets. Outside of the banking system, credit losses so far have been modest: losses in commercial real estate lending have been manageable, private equity backed companies appear to be able to withstand much higher costs of borrowing, consumer confidence has not cracked despite rising mortgage rates and residential construction, in the US at least, has remained strong. Money supply in the US, as measured by M2 is growing again, alleviating pressure on the financial system.
“Our second concern was that inflation would prove much stickier than markets expected and the subsequent repricing of both inflation and interest rate expectations would have unpleasant knock-on impacts on both bond and equity markets. The first part proved correct. Inflation did not fall back to target in either the UK or the US and seems unlikely to return to target on a sustainable basis for some time. Ten year yields rose by about 0.7% in the US to 4.2% and 0.4% in the UK to 3.9%. Yet equity markets rose, completely unperturbed, to record highs. Frankly, this was puzzling. Equity prices are nothing more than the discounted value of their future cashflows, as the discount rate rises that present value falls. More subtly, but no less significant, the nominal return on equity tends not to rise during inflationary periods, meaning that the real return on equity falls. In addition, accounting profits become overstated during periods of inflation as the cost of replacing property, plant and equipment exceeds depreciation. All this should lead to falling and not rising PE multiples.
“With rising yields, our index-linked bond holdings struggled to make headway, despite the larger than expected inflation accruals. They returned -0.5% for the year with most of the negative performance attributable to US TIPS, not helped by Sterling’s appreciation. Whilst a disappointing return, it was ahead of the Bloomberg Global Index-Linked Bond Index which was down 1.9%. The Company’s UK index-linked holdings were a bright spot. We added aggressively to 2028 and 2029 linkers as yields rose over the summer, having generated annualised returns of around 7% per annum on our purchases, and have since taken some profits. Less satisfactory was our holding of Japanese index-linked bonds and Japanese treasury bills which have been poor performers as the Yen continued to depreciate against all major currencies.
“The credit portfolio performed well generating returns of 7.0%, the holdings of speculative grade credit did better returning 10.5%. Spreads have contracted materially which, combined with our cautious outlook for interest rates, has resulted in our taking profits and recycling into treasury bills and investment trust special situations.
“Risk assets performed adequately, returning a little under 5.6%. Equities and property returned 12.6% and 11.6% respectively. Among the best contributors were some of our investment trust holdings. Pershing Square Holdings delivered a return of 47.8%. Originally built during the teeth of the Covid pandemic at an average price of $17.57, the investment has since delivered strong underlying NAV performance which, combined with discount narrowing, resulted in the share price reaching $49.52 at year end. A more recent addition in 2022 was AVI Global Trust which, itself, invests in discounted investment trusts, holding companies and conglomerates. Again, strong underlying NAV performance and discount narrowing led to returns of 28.6% in the year.
“The Company’s infrastructure holdings performed poorly returning -15.1% over the year and it is within this category that the largest detractors to performance are found. Discounts on high quality infrastructure stocks rose dramatically and finished the year at an average of c. 20% across the sector. These discounts cannot be explained by investor concerns that the net asset values of these companies are overstated – all our major holdings reported extensive sales of assets at or above book value. Instead, their performance reflected technical dislocations in the wider alternatives sector of the investment trust market. Able, for the first time in over a decade, to earn reasonable returns on short-dated government bonds, investors have shunned alternative trusts. With the supply of shares fixed (at least in the short term), a collapse in demand meant that price inevitably took up the slack. We think these offer fantastic prospective returns with relatively low risk and have added materially to our holdings such that infrastructure now makes up 8% of the portfolio.”
Manager’s comments on the outlook
“If we are right that the world is in a structurally more inflationary environment, then the outlook for nominal bonds remains poor. This is exacerbated by the fiscal situation in developed countries. The average budget deficit across the G8 is forecast to be 4.6% in 2025, so the supply of bonds will increase while central banks continue to reduce their balance sheets. Added to which there is no imminent sign of recession, nor any discernible term premium in longer dated bonds.
“The outlook for index-linked bonds is more nuanced. Real yields in the US are above 2% across the length of the treasury curve. It appears that the sustainable growth rate of the US economy has risen materially which suggests that these real interest rates are close to fair value. However, the fiscal position is poor and looks set to deteriorate. Real interest rates at these levels will not be sustainable if there is no prospect of bringing fiscal deficits under control. Left unchecked, financial repression – characterised by negative real interest rates – will be necessary. What is less certain is the path. Index-linked bonds trade in sympathy with nominal bonds. If nominal bonds are weak, as seems plausible, index-linked will most likely suffer with them. Yet the long-term prospects look fair or, should financial repression be enacted, excellent.
“Risk assets present a similar conundrum. US equities have rarely been so expensive. The cyclically adjusted PE ratio stands at 34x today, it reached 38x during the “everything bubble” of 2021 and otherwise was only higher during the technology bubble. Market breadth has fallen dramatically as returns are increasingly concentrated in the so-called Magnificent Seven. Microsoft trades on a free cash flow yield of 1.7%. To deliver acceptable returns, from this starting valuation, it needs to be able to grow its free cashflow between 8-10% per annum in perpetuity.
“In attempting to justify these high prices, investors might point to the huge outperformance of US earnings both against the rest of the world and against their own history. While tempting to attribute this to American exceptionalism, that is only part of the story. More significant in recent years has been the contribution from collapsing interest expenses and corporation tax rates. Having termed out their debt, it may be some years before interest expenses rise meaningfully, but it seems unlikely they can fall. With the US running ever larger fiscal deficits, we would not expect corporation tax to continue to fall. But with the possibility of a Trump presidency, nothing should be ruled out. In any event, it seems that this large tailwind to earnings will become a headwind.
“While the prospect for US equities looks poor, the outlook for investment trusts is the most attractive that it has been for years. Discounts on investment trusts are the widest they have been since the global financial crisis. Furthermore, these discounts are broad based and include the larger, more liquid high quality trusts. In response we have added to our investment trust holdings, partly financed by sales of ETFs and partly from cash. We are optimistic that these holdings will provide better returns than broader equity markets.”