(10/13/11) Why These 2 UK Trusts Go for Growth

The rise of China and recent emphasis on dividends, even in traditional growth sectors, is leading these two top trusts to load up, writes Andrew McHattie of the Investment Trust Newsletter.

Managed by Baillie Gifford, we imagine that Scottish Mortgage Investment Trust PLC (London: SMT) is in many subscribers’ portfolios. It is the third largest investment trust in terms of total assets.

This £2 billion ($3.13 billion) global growth trust is generally regarded as a high-quality trust that exemplifies many of the merits of the sector, with low costs, use of gearing, and a longer-term view. That is all true, we think, but there is no getting past the fact the trust has lost a quarter of its assets over the last three months, dumping it on to the very bottom of the sector performance table over this period.

Deputy manager Tom Slater was keen to emphasize the managers’ long-term view, saying that they are investors rather than speculators, with performance assessed on a rolling five-year basis. On that measure, the trust stands up well, ranking seventh out of 31 peer group trusts according to the data we use.

Tom sees reasons to be optimistic, saying that even this year is “pretty good” in terms of global growth, which he expects to come in around 3.5%. That figure is driven, of course, by the faster-growth economies of the Far East, and Tom suggests “China can be a more powerful engine for economic growth over the next 50 years than the US has been for the last 50.”

The managers believe that the rise of China and other emerging economies will transform the global economic scene, and they also believe that stock markets underestimate the power of technological change.

For this reason the trust’s portfolio is stuffed full of growth stocks such as Amazon (AMZN), Baidu (BIDU) and Google (GOOG), plus some more recent purchases of stocks such as Salesforce.com (CRM) and ARM Holdings (ARMH). Tom points out these companies are growing very fast in spite of the economic background.

Technology accounts for almost 20% of assets, along with industrials and consumer services. By geography, the portfolio has around a third of assets in Europe, another third in North America, and the balance in emerging markets.

Tom says he is “pretty comfortable” with the equity gearing of 10%. As managers, Tom says they are not too responsive to short-term market movements, but they are encouraged at present to become a little more aggressive in their holdings.

They are taking some money out of steady growth stocks and putting more into their major growth themes. Tom expects growth to come from areas such as renewable energy, medical firms, and the data explosion.

Scottish Mortgage is an unashamed growth trust that is always likely to outperform during bull markets and underperform during bear phases. As such, its recent poor showing is not a great surprise, given how equity markets have performed.

For long-term investors—and for monthly savers—its attractions remain intact, but you would need to have a positive view on future market performance to buy or hold the shares now. The trust’s discount is steady at 7.8%, and the shares yield 2.1%.

City of Growth
This is Job Curtis’s 20th year in charge of City of London Investment Trust PLC (CTY)—a lengthy reign at a trust where history is important.

City of London started life as a brewery company and owned pubs until 1967, but its approach has been much more sober since then. Indeed, the trust proudly claims the longest record of annual dividend increases of any investment trust, having raised the dividend every year for the last 45 years.

The shares currently yield 5.2%, which is quite a draw when coupled with such stability.

Of course, the argument for dividend investing has been given a huge boost by recent market volatility, and by the apparent fragility of some capital values. In unreliable economic times, when growth may or may not be positive, it can be comforting to receive a good dividend flow.

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Job quotes John D Rockefeller, who asked, “Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” Right now, with interest rates so low and likewise the yields on government debt and bonds, equities seem to offer some of the best payment terms.

Job likes dividend-paying companies for many reasons. He says they must look after their balance sheets, with a focus on cash returns, and that dividends impose a discipline on management when they are thinking of issuing stock or making acquisitions.

He argues that high yield stocks have outperformed over time, particularly in the “sweet spot” where companies can offer an above-average dividend yield but growth as well, which is needed for rising future dividends.

From a long-term perspective, Job reckons equities are “interesting,” with strong dividend growth forecast over the next two years and historically low P/E ratios. He says that at the interim stage, the trust’s portfolio saw 9.8% dividend growth, and that the growth outlook for dividends is “quite attractive.”

For many investors who currently own a range of UK blue-chip stocks, paying dividends and causing a trail of paperwork, a single investment in City of London might be a sensible alternative. The trust invests mainly in UK equities, with just 6% of assets overseas, and seeks to provide long-term growth in both income and capital.

It pays its dividends quarterly. Holdings are chosen using a bottom-up approach that is mainly valuation driven.

Job takes a conservative view, but is quite happy to buy out-of-favor companies. He says the most successful investment of his career was in British American Tobacco (London: BATS), in of course a “deeply unfashionable industry.”

The trust’s top ten holdings at the end of August included BATS, Royal Dutch Shell (RDS-A), GlaxoSmithKline (GSK), Vodafone (VOD), and Diageo (DEO). The largest eight holdings are all multinational stocks with some exposure to faster growing emerging economies, and they all offer high yields.

Job points out that for all of his top ten holdings, the (growing) equity dividend yields are higher than their (non-growing) corporate debt yields, highlighting the value in equities.

He thinks that equity markets are quite naturally focused on the problems in financial markets, placing a higher emphasis on those than on the fundamental performance of earnings and dividends, leaving them looking undervalued. He says “it remains to be seen” whether the Eurozone funding issues and problems in the financial markets more generally will greatly affect the rest of commerce.

The trust is unadventurous by nature, but it is certainly not averse to some higher-beta growth shares.

City of London has a small exposure to mining, with around 4% in BHP Billiton (BHP) and Rio Tinto (RIO), and Job recently bought some shares in Microsoft (MSFT), which now pays a very well covered 3% dividend.

He also owns HSBC (HBC), which he describes as “the most conservative bank in the world” with an emerging-market footprint, and he has just bought shares in Tesco (TESO). “There are lots of terrific income opportunities” around at the moment, Job enthuses.

The overall beta of the portfolio is around 0.85, meaning it should move by slightly less than the market generally.

Talking about the unbroken record of dividend growth, Job says this would not have been possible with an open-ended fund structure, as the trust has had to rely on its revenue reserves from time to time. Investment trusts do not have to pay out all of their income, and can if they wish keep back up to 15% for a rainy day, allowing them to "smooth" their dividend payments in bear markets when companies cut their dividends.

Job says the dividend is almost exactly covered now, but it would have been cut last year had it not been for the revenue reserves. Now the revenue reserve covers roughly one year’s payments, which Job thinks is “about right.” He is optimistic that the trust will not need to dip into its reserves again in the near future.

City of London has no issues with its discount, but the shares—in common with many other higher-yielding shares in the UK income and growth sector—trade on a premium, currently 2.7%. The trust tries to control the premium by issuing shares, but it has persisted for some time.

We never like the idea of buying on a premium, which runs contrary to one of the great advantages of the sector, but we can see why there is a lot of demand for City of London. Over five years, it is ranked fifth out of 19 peer group trusts, and it is closely identified with the virtues of reliability and skilled level-headed management.

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