The Edinburgh Investment Trust plc
Half-Yearly Financial Report
Six Months to 30 September 2017
Investment Objective
The Edinburgh Investment Trust plc is an investment trust whose investment objective is to invest primarily in UK securities with the long term objective of achieving:
1. an increase of the Net Asset Value per share in excess of the growth in the FTSE All-Share Index; and
2. growth in dividends per share in excess of the rate of UK inflation.
The Company will generally invest in companies quoted on a recognised stock exchange in the UK. The Company may also invest up to 20% of the portfolio in securities listed on stock exchanges outside the UK. The portfolio is selected on the basis of assessment of fundamental value of individual securities and is not structured on the basis of industry weightings.
Nature of the Company
The Company is a public listed Investment Company whose shares are traded on the London Stock Exchange. The business of the company consists of investing the pooled funds of its shareholders, according to a specified investment objective and policy (set out on page 11 of the Company’s 2017 annual financial report), with the aim of spreading investment risk and generating a return for shareholders.
The Company uses borrowing to enhance returns to shareholders. This increases the risk to shareholders should the value of investments fall.
The Company has contracted with an external investment manager, Invesco Fund Managers Limited (the ‘Manager’), to manage its investments and to provide the Company’s general administration. Other administrative functions are contracted to other external service providers. The Company has a Board of non-executive directors who oversee and monitor the activities of the Manager and other service providers on behalf of shareholders and ensure that the investment objective and policy is adhered to. The Company has no employees.
Performance Statistics
| Six months to | ||||
| 30 September 2017 | ||||
| Total Return(1) (capital growth with income reinvested) | % Change | |||
| Net asset value (NAV) total return – debt at market value | +0.3 | |||
| Share price total return | –0.6 | |||
| FTSE All-Share Index total return | +3.6 | |||
| The Company’s benchmark is the FTSE All-Share Index. | ||||
| At | At | |||
| 30 September | 31 March | % | ||
| 2017 | 2017 | Change | ||
| Capital Return | ||||
| Net asset value – debt at market value | 759.87p | 768.81p | –1.2 | |
| Share price(1) | 695.50p | 713.50p | –2.5 | |
| FTSE All-Share Index(1) | 4049.89 | 3990.00 | +1.5 | |
| Discount – debt at market value | 8.5% | 7.2% | ||
| Gearing (debt at market value) – gross gearing(2) | 14.5% | 15.9% | ||
| – net gearing(3) | 14.4% | 15.7% | ||
| Retail Price Index(1) – annual change | 3.9% | 3.1% | ||
| % | ||||
| Six months to 30 September | 2017 | 2016 | Change | |
| Revenue Return | ||||
| Revenue return per share | 16.9p | 13.9p | +21.6 | |
| First interim dividend(4) | 5.8p | 5.4p | +7.4 | |
Notes:
1. Source: Thomson Reuters Datastream.
2. Gross gearing: borrowings ÷ NAV debt at market value (both with debt at market value).
3. Net gearing: borrowings less cash and cash equivalents ÷ NAV (both with debt at market value).
4. Dividends declared in respect of the financial year.
Chairman’s Statement
These six month results are reported following the surprise outcome of the UK general election in June and a backdrop of uncertainties arising from Brexit, with its difficult negotiations. Further from home, the political scene is more stable with the economic recovery in Europe. However, political uncertainties have arisen from the Trump administration in the US, together with that country’s growing tensions with North Korea. The consequences of these events, whether favourable or not, are likely to dominate the political and economic landscape for some years to come.
Sterling fell sharply following the result of the UK general election which created some divergence in the performance of internationally exposed companies relative to more domestically orientated businesses. Our portfolio manager Mark Barnett, with an unchanged strategy, continues to focus on the long term fundamentals of the companies he invests in. His Portfolio Manager’s Report gives an overall market review, together with a review of major portfolio changes during the six months.
Performance
The Company produced a positive net asset value (NAV) total return for the six months to 30 September 2017 of 0.3% (with debt at market value). However, this performance was behind that of the FTSE All-Share Index, the Company’s benchmark, which returned 3.6%. The share price total return (share price with dividends reinvested) for the period was –0.6%, with the Company’s share price ending the period at 695.5p, a decrease of 2.5% from the year end share price of 713.5p. Performance was hindered by problems at one of the portfolio’s large holdings – Provident Financial – as the portfolio manager explains in his report.
The discount of the NAV to the share price widened from 7.2% at the year end to 8.5% on 30 September 2017, reflecting the widening of discounts across the sector in the period. At 21 November 2017, the share price of 692.0p was at a 8.2% discount to the NAV of 753.5p (the latest practical date prior to signing this report).
The portfolio continues to be concentrated in a relatively small number of stocks and sectors and its overweight or underweight positions in various sectors will be material drivers of the Company’s relative investment performance.
Dividend
As in previous years, the Board continues its aim to rebalance the interim and final dividends towards the interims, whilst simultaneously aiming to at least maintain the final dividend. Consequently, the Board has declared a first interim dividend of 5.8p (2016: 5.4p), an increase of 7.4%. This will be paid on
30 November 2017 to shareholders on the register on 17 November 2017, with shares quoted ex-dividend on 16 November 2017.
The Board, and the portfolio manager, remain cognisant of the Company’s objective to grow the dividend payable to shareholders by more than the rate of UK inflation over the long term.
Borrowings and Gearing
The Company has in place a mixture of fixed and floating rate debt. The former is the Company’s £100 million 7¾% debenture which matures in 2022 and the latter a £150 million, 364 day bank credit facility. By this means, Mark has the ability to vary the gearing level of the portfolio depending on his view of the market. During the period under review aggregate borrowings ranged between £187 million and £232 million, and ended the period at £189 million – equivalent to gross gearing of 14.5%.
Board Succession
As I said in my letter to shareholders dated 13 July 2017, I am very pleased that the Board has appointed Glen Suarez to succeed me as Chairman on my retirement and this will take effect from today. Glen has a wide experience of the financial services sector and has already made a substantial contribution to the Company since joining the Board in 2013. It is the Board’s view that Glen has the necessary skills and experience to steer the Company going forward. I am confident that I leave the Company in good hands with Glen and my fellow Directors.
Outlook
The ongoing Brexit negotiations, recent election results across Europe and continued higher levels of inflation driven in large part by weaker sterling present a continued theme of uncertain market conditions.
The Board remains confident that Mark’s high conviction approach to investment, driven by fundamental careful stock selection, remains the correct approach for such uncertain times. This approach will inevitably lead to periods in which portfolio performance diverges from that of the benchmark FTSE All-Share Index, as we have seen over this period, and therefore may result in periods of underperformance, particularly in sharply rising, momentum driven markets. However, Mark’s focus, as has been the case in the past, remains on adding significant value by owning businesses which are undervalued by the market, and are able to deliver dividend growth, which ultimately drives positive total returns over the long term.
Jim Pettigrew
Chairman
22 November 2017
Total Returns to 30 September 2017
| 6 mths | 1 yr | 2 yr | 3 yr | 5 yr | 10 yr | |
| NAV (debt at | ||||||
| market value) (%) | 0.3 | 8.0 | 19.6 | 34.2 | 91.2 | 125.0 |
| Share Price (%) | –0.6 | –0.6 | 7.9 | 27.3 | 62.1 | 129.1 |
| FTSE All-Share Index (%) | 3.6 | 11.9 | 30.8 | 27.8 | 61.2 | 75.2 |
Source: Thomson Reuters Datastream.
Portfolio Manager’s Report
Market Review
The recent six-month period has been dominated by two distinct forces – the turbulent political environment and the improving global economy. The combination of these two differing factors led to increased polarisation of sector performance in the UK stock market.
The FTSE 100 Index reached a record high in early June, led by a rally in the oil and mining sectors, and sterling fell in response to the surprise outcome of the UK general election. However, into the second half of the period, growing tensions between the United States of America and North Korea led to nervousness in global equity markets. Renewed strength in sterling, as Brexit negotiations saw a two-year transitional deal suggested by the Prime Minister and the Bank of England hinted that it would raise interest rates in November, further dampened the progress of the UK equity market.
Portfolio Strategy and Review
The Company’s net asset value, including reinvested dividends, rose by 0.3% during the period under review, compared with a return of 3.6% (total return) by the FTSE All-Share Index.
The portfolio’s performance was most negatively impacted over the period by its holding in Provident Financial. The company issued a profit warning in August, downgrading earnings forecasts for its Consumer Credit Division from a profit of £115 million to a loss of between £80-120 million for the year to 31 December 2017. Additionally, the business announced that subsidiary Vanquis Bank is co-operating with an FCA investigation into its Repayment Option Plan ancillary product and the resignation of its formerly well-regarded chief executive. The business as a whole remains profitable, although no dividend will be payable for the current financial year.
Very regular contact with the company, including a visit to its head office in Bradford, has provided reassurance that, while the home-collected credit business has been damaged, this is not irretrievable and that there is a long term future for that business. There is no certainty on the timing or outcome of the FCA review of Vanquis, but it is noteworthy here that, in providing the Vanquis credit card, Provident Financial provides a valuable service to the under-served sub-prime segment of the population.
The portfolio’s holdings in the tobacco sector – Altria, British American Tobacco (BAT), Imperial Brands and Reynolds American – have delivered strongly positive performance over a very long period. However, they detracted over the past six months, despite the successful conclusion by BAT of the acquisition of Reynolds American in a part shares, part cash deal. The combined entity is well positioned to exploit next generation products, particulary in the key US market. The stock market focused on plans announced by the US Food and Drug Administration to launch a consultation on lowering nicotine levels in cigarettes. This regulation may be expected to take some time to come to fruition, but this is an industry accustomed to dealing with headwinds. In the meantime, the companies’ combined focus on pricing power, cash conversion and product innovation should continue to provide a reliable source of income.
The negatives above outweighed and overshadowed strong performances from elsewhere in the porfolio. This included companies whose share prices were previously hurt by their exposure to the fall in sterling and perceived challenges to the UK economy – and which had performed poorly in the previous year in the aftermath of the UK referendum and US election. Advantage had been taken of the share price weakness to add to holdings, believing that the sterling fall was excessive, that the implications for sector performance were being over-simplified and that share prices could react positively to a minor improvement in the prevailing stock market sentiment.
Amongst these, holdings in Next, easyJet, Legal & General, Thomas Cook and BCA Marketplace all delivered strongly positive performances over the period. Next saw its shares rise strongly on comments of a “somewhat less challenging” outlook for the business, with growth of its on-line Directory business picking up pace. easyJet also surprised the stock market with a better-than-expected trading statement, while Thomas Cook delivered robust share price performance following an update which indicated growth across multiple regions, with a notable rise in customer demand for Turkey following the 2016 terrorist attacks. BCA Marketplace confirmed that its core auction-related vehicle remarketing division has traded well this year, while its vehicle buying division, led by the WeBuyAnyCar brand, was delivering “sustained double digit volume growth”.
Other holdings to perform well during the recent period included those which have been more consistent long term performers. Burford Capital’s impressive progress in litigation finance continued unabated, with the company demonstrating an impressive ability to deliver good returns in a growing market, while investing its asset base and diversifying into fund management. HomeServe confirmed it is successfully expanding its home emergency and repair services business from its core UK market into the high growth potential of the US. London Stock Exchange shrugged off a brief share price fall on the feared impact of Brexit and the failure of its proposed merger with Deutsche Borse – and delivered strong organic growth, benefiting from inflows into passive products and rising demand for benchmarking, data and analytics. Compass’s dominant global position in contract catering saw it growing fast in the still relatively untapped US market. Rentokil Initial’s shares continued to rise as the company focuses on the structural growth opportunites in its highly profitable pest control division.
In terms of portfolio activity during period, new investments were made in Assura, a real estate investment trust specialising in healthcare property; the company is one of the major investors in GP surgeries where rents are set either in relation to inflation or other centrally determined benchmarks. As a result, the future income streams appear robust. Eddie Stobart Logistics was a new holding. The company operates a large fleet of trucks and other logistics services on a shared user basis which generates market-leading profit margins. Royal Dutch Shell ‘A’ was added to the portfolio during the period. Like BP, the company is now demonstrating that it can cover the cash costs of investment, operations and its dividend at an oil price of $50 per barrel or below. As mentioned earlier, the holding in Reynolds American was taken over by BAT, with the portfolio receiving a mix of BAT shares and cash. The holdings in Game Digital, N Brown and SSE were sold. Game and N Brown have continued to experience displacement of their traditional retail products by digital or on-line new entrants and as a result their long term prospects were reassessed. SSE was sold to release cash for new investment opportunities but also with a view to the deteriorating risk outlook for politically sensitive utilities in the current climate.
Outlook
The performance of the UK stock market will continue to be dominated by the countervailing forces of better than expected global economic growth and ongoing UK domestic political concerns. A sense of complacency may now exist over the global growth outlook, which has led to narrow but rising market levels, low volumes of shares traded and little volatility in share prices. This positive backdrop has also led to a renewed belief in a so called “goldilocks” environment, where the key economic variables of growth, inflation and interest rates are set up to sustain a perfect environment for rising stock markets. This may prove to be the case over the near-term, and is certainly illustrated by the further fall in market volatility, but this kind of stock market status quo does not tend to last too long. It is also worth remembering that a combination of high valuations in certain sectors, shifting monetary policy and a volatile geopolitical environment may still provide a catalyst which alters this bullish global outlook.
By contrast, the market seems incapable of looking beyond the uncertainty of the Brexit negotiations when it comes to valuing sterling assets which, by historic standards, are now heavily discounted. Again, this seems unlikely to persist for long.
The best performing sectors this year have been those most exposed to this bullish global scenario, which has created opportunities to invest within the more domestically exposed sectors that have performed poorly and which look undervalued. The focus of the portfolio has been steered towards these sectors over recent months. As previously mentioned, there is an apparent strong consensus pessimism about the outlook for the UK economy, despite recent data points indicating a continuation of current growth trends. Although a materially improved domestic outlook may be unlikely, there should be some respite from the pressure on real incomes as elevated inflation levels decline next year and wages continue to grow. This gives us confidence that an excessively bearish view is already reflected in domestic share prices.
If we proceed cautiously through employing a well-tested investment process based on fundamental company analysis and a prudent approach to valuation, there are opportunities for profitable investment in this market which provide a rising flow of dividend income and should protect capital in the event of more volatile market conditions.
Mark Barnett James Goldstone