John Baron: Seven magnificent UK investment trusts

The UK equity market continues to languish at a c40 per cent discount to global markets. Commentators and investors alike have all but thrown in the towel. Some MSCI PIMFA benchmarks used to monitor my portfolios’ performance have recently reduced their UK weighting. Yet, I dare to suggest there is hope. Catalysts for a re-rating lurk in the shadows. As such, I have been increasing my portfolios’ exposure to the UK in recent months, at the expense of overseas equities, courtesy of seven trusts that promise to outperform their respective benchmarks as the UK plays catch-up – let’s call them the UK’s magnificent seven.

Winds of change

Explanations as to why the UK market remains cheap are well rehearsed: an overweight exposure to ‘old economy’ sectors (at the expense of more highly rated technology companies); five prime ministers in eight years and the concurrent political challenges; onerous listing rules and obligations seeing many companies move to the US; a huge divestment in recent decades by pension funds of equities in general and the UK in particular; and a perception that economic growth has been relatively pedestrian have all contributed to the malaise. Any good news has paled into insignificance. The bears have been rampant and have carried all before them.

A constant investment discipline is to question the consensus – outperformance cannot be achieved without deviation from the benchmark. In doing so, the journey is better informed if humility is your companion. In asking questions, one is always balancing sentiment and the fundamentals but also looking at the possible catalyst, or catalysts, that could spark a turnaround – even if it is a slow corner, and the ascent promises to be anything but fast. In doing so, I suggest the UK equity market appears to be in the foothills of what will be an enduring recovery relative to overseas markets.

Certainly, in contrast to the perception created in certain circles, economic growth has been among the fastest across the continent since Brexit, as evidenced by an unemployment rate remaining well below the EU average and inward investment continuing to compare well. The corporate sector is in good shape, with company balance sheets strong and investment gathering pace. Personal taxes are higher than liked but one of the most generous furlough schemes and energy support packages ensured no one was left behind after the pandemic. Meanwhile, interest rates are now on the turn even though the Bank of England again risks being behind the curve in responding to the inflation outlook.

Perhaps another misconception should be tamed – the view that the UK market is bereft of technology. It is true that the UK, like many other countries, is not home to the likes of the US’s Magnificent Seven companies. For some, the jury is still out as to whether the lofty ratings afforded these companies are justified. Regardless, many large British companies are busy embracing technology and the application of digital tools, including artificial intelligence (AI). Examples include London Stock Exchange (LSE), Sage (SGE), Experian (EXPN) and RELX (REL) – and the price tags are disproportionately cheaper.

What of possible catalysts? In an increasingly uncertain world, the UK offers political stability. The election of a Labour government contrasts starkly with far-right parties gaining political influence on the continent and the high stakes in the US presidential election. The parliamentary system was always more robust and responsive than its detractors believe, but first past the post ensures the minority of extremists in our society, whether left or right, find it difficult to break into the political mainstream – proportional representation has conjured an ill wind on the continent. This is being acknowledged by international investors, who are also encouraged by the continued thawing in relations between the UK and EU.

The drive by City regulators to relax London’s listing rules, and so help stem the flow of companies moving to international rivals, offers hope. In the biggest shake-up in decades, rule changes simplify the process for companies coming to market, including the elimination of the two-tier system of standard and premium listings; relax restrictions on dual-class shares to confer founders with more voting rights; remove the need for firms to provide a three-year financial record; and reduce shareholders’ rights regarding M&A decisions. Despite the governance concerns of some, the rule changes bring London more in line with international competitors. The regulation of the graveyard has little future.

However, more will need to be done. The chancellor is looking to boost pension fund investment in the UK. This may involve consolidating the myriad local government schemes into a model similar to that of Canada, which evidence suggests would encourage greater investment in domestic equities and infrastructure assets. The government may also be looking at mandating the UK’s huge institutional pension funds to allocate a higher proportion of assets to domestic companies. Overseas pension funds certainly favour their domestic markets, and tax breaks confer responsibilities. Given the steep decline in UK exposure in recent decades, such changes would be a fillip to the market over time.

Perhaps another factor is worth mentioning. Current headlines focus on inflation falling and the speed of interest rate falls. Yet previous columns have highlighted the economic and geo-political forces that suggest inflation over the medium to long-term will remain higher than previously – with three becoming the new two. Although this is an improvement on recent years, given the implication for discount rates, it is high enough for questions to be asked regarding the lofty ratings afforded the larger US technology companies. Once the penny drops, investors will have another reason to look at the UK market.

The seven

The following seven companies have been recently bought across the 10 live investment trust portfolios managed in real time on the website www.johnbaronportfolios.co.uk, including the two regularly covered in this monthly column.

Temple Bar Investment Trust (TMPL) focuses primarily on UK securities and seeks to provide income and capital growth above its benchmark, the FTSE All-Share Index. However, around 30 per cent of the portfolio is invested overseas. Since RWC Asset Management took over the running of the portfolio in 2020, performance has been impressive, with the experienced management duo of Ian Lance and Nick Purves not being shy to take contrarian positions – recent figures suggesting the portfolio is standing on less than nine times last year’s earnings. The team seeks fundamentally sound businesses, with strong balance sheets and low gearing – and unduly poor sentiment awaiting a catalyst to inspire.

Finsbury Growth & Income (FGT) recently reported another set of disappointing results which underline its underperformance in recent years. This has been acknowledged by Nick Train, the lead manager, and by the market given its discount – until recently, the trust usually traded at around par. Yet we remain committed to it. The manager’s longer-term record remains impressive – his focus on good quality companies with strong finances and robust moats has stood the test of time. As one would expect, there is no change to the investment approach. Indeed, Nick has recently been adding to the company’s UK exposure at the expense of its few overseas holdings.

Henderson High Income (HHI) focuses mostly on larger UK companies to generate a high and growing level of income. Since David Smith took over the management 10 years ago, the trust has enjoyed a good track record over most time frames relative to its benchmark (80 per cent FTSE All-Share Index/20 per cent ICE BofA Sterling Non-Gilts Index). Meanwhile, the progressive dividend policy is supported by meaningful revenue reserves.

The Merchants Trust (MRCH) seeks an above-average level of income and income growth, together with long-term capital growth, by investing in a diversified portfolio of mainly higher yielding and larger UK companies. The company has a very good track record under its respected and long-standing manager, Simon Gergel. This record has been assisted by its gearing, and a focus on good quality and financially sound businesses has helped the company steer through some turbulent waters. This is perhaps best illustrated by its record of having paid increasingly higher dividends year on year for 42 years – recent figures show the annualised growth rate standing at 6.4 per cent, well above the annual rate of inflation at 3.8 per cent.

Fidelity Special Values (FSV) similarly seeks outperformance of the FTSE All-Share index via businesses that stand on significant valuation discounts, and that possess attractive growth potential together with low levels of debt. Again, the portfolio’s prospective price/earnings ratio stands on material discount to the broader UK market. It is noteworthy that earnings proved resilient in 2020. Alex Wright, the manager, invests across the market cap spectrum but remains overweight smaller companies given the value and outlook. The company has performed well – its NAV has handsomely beaten its benchmark over both the short and long-term.

The Mercantile Trust (MRC) focuses on UK medium and smaller companies while seeking to provide long-term dividend growth at least in line with inflation. The trust has a consistent track record of outperformance relative to its benchmark (the FTSE All-Share ex FTSE 100 and investment companies) over both the short and long term. We concur with the management’s view that this segment of the market in particular offers promising returns, having nearly doubled the trust’s gearing to c14 per cent recently – this is a meaningful increase, and one that will benefit asset performance over time if contributing to volatility shorter term. Significant in-house resource adds to the investment case.

Montanaro UK Smaller Companies (MTU) focuses on growth businesses that typically enjoy high barriers to entry, a sustainable competitive advantage and a track record of solid earnings growth. Like most in its sector, the trust has underperformed in recent years, but an investment house specialising in smaller companies, a good long-term record and a focus on financially robust businesses bode well. The trust is quietly confident about prospects. As Charles Montanaro, the lead manager, suggested to me: “Our confidence in the outlook is perhaps best reflected in our recent decision to buy 1 per cent of MTU ourselves.”

Meanwhile, the company pays a quarterly dividend equivalent to 1 per cent of net asset value (NAV) at quarter-end.