We are pleased to present our unaudited half-year results for the six months ended 30 June 2023. You can read the chairman’s statement and portfolio manager’s report below, and you can download the full report here.
This is my first report to shareholders having succeeded Arthur Copple as Chairman of the Company in May 2023. During Arthur’s tenure as Chairman, your Board had to take a number of strategic decisions including changing our Portfolio Manager and deciding to retain our value focused investment strategy. We believe that both decisions were the correct ones for shareholders and I would like to thank Arthur, both personally and on behalf of your Board, for his leadership and wise counsel during his tenure.
The total return of the FTSE All-Share Index was +2.6% in the period. I am pleased to report that the Company’s Net Asset Value (“NAV”) total return was +3.4%, outperforming the Index, and that the share price total return was +2.5%.
In common with many other trusts, the Company’s discount to NAV during the period widened slightly to 6.5% from 5.6%. Your Board has continued to be active in pursuing its buy back policy. During the period 15,364,821 shares were bought back at a cost of £31.1m. This has the effect of accreting to the remaining shares’ net asset value and reducing the supply versus demand imbalance in the market.
Your Board declared a first interim dividend of 2.3 pence per share which was paid on 30 June 2023. Your Board has also agreed that the second interim dividend will also be 2.3 pence per share. The second interim dividend will be payable on 29 September 2023 to shareholders on the register of members on 25 August 2023. The associated ex-dividend date is 24 August 2023.
It is not my intention in these communications to comment on macro-economic forecasts, however there are signs that some of the inflationary pressures in the UK are starting to ease with a concomitant decrease in the pressures for monetary tightening by the Bank of England.
However, principally your Board continues to believe that our Portfolio Manager is correct in their conviction that a portfolio of fundamentally sound businesses, bought at attractive valuations, is the best predictor of investment return over time and that our value strategy will reward shareholders accordingly.
Portfolio manager’s report
Stock markets have had to contend with further significant interest rate rises in the first six months of 2023. In the US, the UK and Continental Europe, Central Banks have been raising rates to bring inflation back to the target level of around 2%. At the beginning of the year, there was some optimism that rates may not have to rise too much further, however those hopes have subsequently been disappointed by the continued strength of the economy and some concerning signs that inflationary pressures are becoming embedded in consumer psychology. This has been particularly the case in the UK, where inflation readings have surprised to the upside for several months now. Although there are signs that these pressures are now easing somewhat, it is hard to know how much further rates will have to rise from today’s levels  and how deep and protracted any resulting recession may be. At the current time, however, most companies continue to enjoy the benefits of relatively benign economic conditions and corporate profitability is generally strong. In contrast, Chinese economic growth had been expected to bounce back strongly in 2023, post the COVID lockdowns in 2022; however this has not been the case and, here, the authorities have been cutting interest rates to stimulate growth.
Stock markets have also had to contend with the failure of several regional banks in the US. These failures were ultimately the result of lax management controls and poor regulatory oversight but nevertheless they raised fears of a broader contagion and led to large deposit outflows at Credit Suisse, culminating in its forced purchase by UBS at a significant discount to an already depressed share price. Quite quickly, however, relative calm returned to financial markets as it became clear that Credit Suisse was an outlier amongst the European banks and thereby not symptomatic of broader weakness in the banking sector. Our view throughout has been that the banking system is sound and that we were not about to witness a repeat of the 2008 financial crisis. This belief was borne of the fact that banks’ asset quality is good, liquidity is strong, and they hold around three times the amount of capital that they did then. Banking regulators throughout the world have spent the last fifteen years ensuring that the Banks are financially strong and that accordingly they can continue to lend even in a stressed environment. We don’t believe that this effort has been for nought.
Given the headwinds of rising interest rates and fears over the stability of the banking system, it is surprising perhaps that most stock markets fared well in the first half of the year, with many delivering double digit returns. The exception in this instance was the UK market which delivered just a small positive total return in the six months.
The Trust outperformed the UK market over the period, helped by strong performances from Marks & Spencer, Centrica, Easyjet and Standard Chartered. Anglo American, Pearson and TotalEnergies were detractors from the portfolio return in the period.
Marks & Spencer continues to execute well in both food and clothing, taking further market share from its competitors. The company has an excellent brand, but for many years has failed to realise its true potential. There are clear signs that this is now changing at a time when the stock market continues to be sceptical. The company delivered a strong set of results in May and profit expectations for the current financial year have increased. Nevertheless, the company is still modestly valued, in our view, even though it still has much in the way of unrealised profit potential.
Centrica continues to perform strongly in several areas. At British Gas, the company is benefitting from a more favourable competitive environment, following the demise of several of its competitors in 2021, whilst its trading business is performing strongly on the back of tight liquefied natural gas (LNG) markets. In combination with high electricity prices and an increase in the capacity of the company’s Rough gas storage facility, these factors have driven meaningful upgrades to near-term profit expectations. The company continues to be valued on a price-earnings ratio of less than six times despite having significant excess cash on its balance sheet. We believe that the company can play a meaningful role in the upcoming energy transition and that accordingly its profits can continue to grow over time albeit with some cyclicality along the way.
Easyjet has been struggling to restore profitability post the pandemic and remains some way short of its profit potential. Nevertheless, there is little sign yet that interest rate rises are dampening demand and airline bookings continue to be strong. As a result, the company has seen some profit upgrades, prompting a sharp upward move in its share price from depressed levels.
Standard Chartered has been a beneficiary of rising dollar interest rates, which in turn have led to higher income growth and should thereby help the bank achieve its profitability targets. Although the large increase in interest rates could lead to credit stresses and increased loan loss provisions, the bank has been significantly de-risked over the last few years and lending standards are now much improved. It is possible and maybe even likely therefore that credit provisions will not need to be significantly increased from current levels. The company’s shares are valued at around seven times this year’s expected earnings and at a meaningful discount to its asset value. At the start of the year, First Abu Dhabi Bank considered making a bid for the company and whilst nothing came of it, the episode served to highlight the strategic value of the company.
In the six months, Anglo American fell on fears that an increasingly hawkish Federal Reserve would raise interest rates to such a point that demand for commodities would be adversely affected. The company also announced slightly disappointing results at which it said that its north of England Woodsmith project to bring polyhalite fertiliser to the market was running behind schedule and would be more costly to develop than originally expected. The company’s shares are currently valued at around eight times this year’s consensus expected earnings and offer a dividend yield of around 5%.
Pearson continued to trade well and the hoped-for recovery in earnings is in our view very much on track, however, the company earns most of its profits in dollars and therefore some weakness in the dollar has led to small downgrades in sterling profit expectations. Over the last few years, the company has had to navigate a difficult transition from print to digital publishing in the North American higher education market although it looks to have reached an inflection point and profits are now growing once again. In 2021, the company received two separate bid approaches from the private equity firm, Apollo, and although both bids were rejected by the management team as undervaluing the company and therefore came to nothing, the approaches again serve to highlight the likely undervaluation in the company’s shares.
TotalEnergies underperformed on continued weakness in the oil price, resulting from fears of recession, coupled with some strengthening in the pound against the euro. The company is currently valued at less than six times this year’s consensus expected earnings.
In the six months under review, the Trust purchased shares in Stellantis, a company formed by the merger of Fiat Chrysler and Peugeot in 2021. The rationale for the merger was to combine the European strength of the Peugeot business with the North American strength of Fiat Chrysler. Combining the entities has allowed for significant cost savings and created a stronger and more diversified business. The company is priced on a historic price earnings ratio of less than four times and has a dividend yield of around 8%. In 2022, the auto industry enjoyed high profitability as strong demand post COVID, coupled with muted supply drove price increases in most markets. Whilst profitability is likely to decline in future years as industry conditions normalise, in our view, the company would nevertheless continue to be very attractively valued. The company has significant net cash on its balance sheet, equating to almost half of its market capitalisation.
The relatively muted performance of the UK equity market in the first half of the year contrasts with strong returns elsewhere. In the US for example, the Nasdaq index of Technology shares had its best first six months in 40 years. The UK therefore remains very out of favour with many investors who continue to sell UK assets to channel money overseas. Here investment prospects are seen to be more exciting even though a large portion of the profits of companies listed in the UK are derived from outside the UK.
The result of this negative sentiment towards the UK however is that UK listed stocks are valued at a significant discount to their overseas listed peers for no other apparent reason than they happen to be listed in the UK. For example, Shell is valued at just 6.5x 2023 estimated earnings, whereas the US listed Exxon Mobil is valued at over 11x. In banking, Barclays is valued at just 0.5x the value of its shareholder equity, whereas the US investment banks are valued at around 1x. Whilst many are taking a dim view of UK economic prospects, it is important to remember that we buy companies and not economies. The companies in which the Trust is invested are viewed as sound, conservatively run businesses with good balance sheets and capable management teams.
Many of the CEOs that we talk to express frustration with the low multiples that their businesses attract, and clients often ask what is likely to cause these shares to re-rate. The answer of course is that we don’t know for sure, except to say that one doesn’t need the shares to re-rate to get a very attractive investment return. We should remember that a company on a price-earnings ratio of 6x, which turns 90% of its profit into cash (a typical conversion rate), offers a free cash flow yield of 15% and that all that cash can be used to drive shareholder returns either in the form of dividends or share buybacks, whilst holding debt at a constant level.
If said company paid out one third of its free cash as a dividend (dividend yield 5%) and used the remaining two thirds to buy back shares, the company would retire 10% of its shares in issue. This in turn would mean that for the same level of profits, earnings per share (and therefore dividend per share) would increase by 10% in the following year and the shareholders’ total return would be 15%. If the shares were to re-rate to 8x, this would drive an additional return of over 30%! These are perhaps obvious points to make, but it is nevertheless surprising how many investors seem to forget them.
Whilst it is somewhat frustrating that UK listed shares continue to attract such miserly valuations, the attraction for the long-term investor is significant as stock market history has shown that the best predictor of long-term future investment return is starting valuation. Time and time again, those that have invested in highly valued assets have been rewarded with suboptimal long-term returns. Conversely, those that have invested in lowly valued, but fundamentally sound businesses, which did not happen to fit with the prevailing investment narrative at the time of purchase, have enjoyed outsized gains. Whilst we cannot know when the improved fundamentals of many of the Trust’s holdings will be reflected in share prices, the Trust’s shareholders should take much comfort from the fact that the lessons of stock market history are very much on their side.
Ian Lance and Nick Purves
 As at the date of publication, 18 August 2023, UK and US interest rates stand at 5.25% and 5.50% respectively.
All valuation data is sourced from Bloomberg as at the date of publication.
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