BlackRock Commodities Income (BRCI) has a conviction-led approach to delivering a high income from the global mining and energy sectors. The shares currently yield 5.7%, considerably more than funds exposed to many other areas of the market. The managers have flexibility to invest in equities and fixed income to generate this income. With the top ten holdings currently accounting for 51% of total assets, relative to most equity funds it can be considered highly concentrated.
Managed by Olivia Markham and Tom Holl, BRCI typically has a roughly even split between mining and energy stocks. Reflecting the income mandate as well as the current outlook of the managers, a significant proportion of the trust is invested in the larger, diversified companies within each sector. The managers believe that within both of these sectors, diversified mega-caps are hugely cash-generative at current commodity price levels. With solid balance sheets and management focused on shareholders, they seem set fair for dividend hungry investors.
BRCI’s objectives are to achieve both an annual dividend target and, over the long term, capital growth. The board considers a “reference index”, of 50% EMIX Global Mining and 50% MSCI World Energy Index to compare performance, but does not see it as a benchmark, given the high-income mandate of the trust. Over the longer term, during what has been a severely volatile time for mining and energy companies, the trust has not kept pace with the reference index. 2018 started very positively, with the managers generating significant outperformance of the reference index, only to see worries of a China slow down and trade wars, erode it. BRCI has started 2019 in a positive manner, with the NAV + 1.9% at the time of writing, outperforming the AIC peer group which is -0.6% in NAV terms.
Income has been (and continues to be) a major focus for the managers and board. However, the trust was not insulated from the dividend cuts experienced by the sector, and the board reduced the dividend from 6p paid in 2015 to the current level of 4p. In the recently published annual results, the board has renewed its commitment to targeting 4p for the financial year ending 30th November 2019.
As at the end of November 2018, revenue reserves stood at 0.6X the current 4p annual dividend level. The board has stated that it will look to protect any future shortfall in earnings with revenue or capital reserves, which in our mind indicates that the dividend yield of 5.7% looks relatively secure. At this level, the trust yields considerably more than most other areas of the market - Global Equity Income investment trusts for example yield 4.1%.
The managers continue to be optimistic in their outlook for the energy and mining sectors, believing 2019 will continue to see high levels of free cash flow translating into strong dividend payments. The fact that both the energy and mining sectors are under-owned by institutional investors gives the managers hope that once confidence on the global economy returns, investors will benefit from a rerating.
The shares trade at a discount of 5.3% at the time of writing, and over the past ten years the shares have rarely looked cheaper relative to their own discount history. Yielding 5.7%, BRCI continues to be an attractive and differentiated source of income for a portfolio.
|Discount of 5.3% looks anomalous for a trust with such a high yield
||Relatively small trust
|High income, with dividend backed by a committed board
||Unlikely to perform well if global economy tips into recession
|Defensive and broadly spread portfolio, managed by specialist team
||Strong sterling could undo any earnings growth from underlying portfolio
BlackRock Commodities Income’s objective is to achieve both an annual dividend target and, over the long term, capital growth. It typically has a concentrated portfolio, with the top ten holdings currently representing 51.4%. In total, the managers expect to have a total of between 40-50 holdings, focussed on their best ideas in the energy and mining sectors in roughly equal proportions.
TOP TEN HOLDINGS AS AT 31st December 18
% OF TOTAL ASSETS
|Royal Dutch Shell
|First Quantum Minerals 7.25% 2022
|Vale - ADS
The trust has an overwhelming income mandate and invests in equities and fixed income to provide as high an income as possible for shareholders. The current split between energy and mining can be seen in the graph below. Within the mining exposure, around 11.4% of the trust’s portfolio is represented by fixed income, which means that the “true” equity exposure to each sector is more finely balanced.
Portfolio sector split
The portfolio is constructed using top-down and bottom-up research, but the team set great store by meeting companies. The top-down analysis is formed by views on the medium-term outlook for commodity and oil prices. Much of this macro view is based on views influenced by company meetings. The trust’s current positioning is a case in point, with BRCI most exposed to the very large diversified miners who are the lowest cost producers of metals globally. According to Olivia, they are likely to be “cash machines” for the forseeable future, with low cap-ex requirements and an ability to extract and sell their products for a high cash margin. As we discuss in the performance section, this approach has done the trust well over the past year or so and was a decent contributor to outperformance of the benchmark in the first half of the year. Worries over the impact of trade wars have dulled performance from the mining sector somewhat.
Within the mining sector, but married to what they are hearing in the energy sector, the team have been increasingly putting money to work in the battery materials and renewables sectors, preparing for what they describe as the inevitable upcoming energy transition. This is both in equities, but also in fixed income. For example, the team report that they are able to invest at attractively high yields in bonds issued by lithium miners, who cannot access bank finance in the traditional way because of the lack of an effective hedge (for the banks) for the lithium exposure. The managers are positive on the prospects for the lithium companies they hold, given their role in the energy transition to electricity and electricity storage, and are so very happy to earn such high returns. Overall, around 3.1% of the portfolio is directly invested in electricity producers (ENI) and distribution.
On the energy side of the portfolio, the team’s earlier decision to ramp up their investment in exploration and production (E&P) companies looked like a good move when the oil price continued its rise from 2017 into 2018. The team had started to take profits when oil hit $85 in September 2018, but admit they could have been more aggressive after the oil price fell precipitously in Q4. Having been at c 16% when we last wrote on BRCI in August 2018, the team still have 8.4% exposure to E&P companies, which they characterise as solid, with relatively low gearing, and which should deliver healthy free cashflows assuming an oil environment of $50-60 per barrel.
Given the lack of clarity on global GDP, the team are retaining their exposures to the big integrated oil producers. They reason that cap-ex in the sector still hasn’t recovered, and whilst there is excess supply globally, there are signs that the lower oil price is choking some of it off. With balance sheets very healthy, and a focus from the larger companies on shareholder returns, they are being paid to wait (through high dividends) for the recovery. This reflects the team’s view that they want to own stocks that can grow profits in a flat market for commodities, but also benefit from upside to commodity prices. This higher quality preference is a reflection of the trust’s income mandate, with the managers focusing on solid companies that are good allocators of capital – which tend to have an attractive dividend policy. The managers argue that taking an income approach to such a cyclical area of the market makes sense, especially as dividends have been a major driver of total returns for the sector over the longer term.
The team continue to be positive on both energy and mining. Withinboth sectors, the team continue to hold the view that increasing management focus on shareholder returns, and the corresponding lack of investment in supply will mean attractive free-cash flows and dividends for investors. Both sectors are under-owned by institutional investors, and in Olivia’s view remain highly attractive from an income perspective. Prices of shares and commodities have been blown off course by trade war headlines, but the managers believe the fundamentals remain strong. Olivia observes that the greatest risk is a global recession, in which the trust will struggle to perform. Dollar weakness would also hurt, particularly with regard to dividends given most companies report earnings in dollars. However, Olivia points out that dollar weakness also has the effect of boosting demand for commodities and energy from emerging markets, so the negative effect from dollar weakness is perhaps more nuanced.
The trust operates a flexible gearing policy, which depends on prevailing market conditions and over the past year has fluctuated between around 11% and 5%. The graph below shows the past five years’ history. It is worth noting that this includes the trust’s derivatives-based fixed income exposure, as well as a traditional overdraft facility. Overall, the team tend to balance gearing with fixed interest holdings, which means that shareholders do not tend to have a significantly geared equity exposure.
As we refer to in the portfolio section, the managers are finding interesting opportunities in the fixed income markets, particularly with various lithium companies that find it difficult to borrow from banks, given the banks can’t hedge the lithium exposure. As such, the team report achieving coupons as high as 11% by having exposure to companies such as Nemaska and Pilbara. These bonds enable a significant pick-up over the trust’s cost of borrowing.
BRCI’s objectives are to achieve both an annual dividend target and, over the long term, capital growth. The board considers a “reference index”, of 50% EMIX Global Mining and 50% MSCI World Energy Index to compare performance, but does not see it as a benchmark, given the high-income mandate of the trust. As we discuss in the dividend section, the trust has come through a difficult period for dividends generally, and all the signs are that this is now very much behind it.
In a total return sense, the team’s focus on income and higher quality stocks means that BRCI should generate its relative outperformance of the reference index in flat or falling markets. However, during what has been a severely volatile time for mining and energy companies, the trust has struggled against it. Nevertheless, the trust’s more conservative approach is evidenced by the fact that it has beaten its peers in five of the past eight calendar years. BRCI has started 2019 in a positive manner, with the NAV + 1.9% at the time of writing (to 29th Jan 2019), outperforming the AIC peer group which is -0.6% in NAV terms.
DISCRETE ANNUAL RETURNS VS PEERS AND INDICES
Source: Morningstar/Kepler Partners
In the graph below we illustrate the trust’s NAV total return performance relative to the reference index and global equities over five years. Prior to this period, it is worth noting that the trust protected capital far more effectively than peers during the severe down cycle for natural resources. Latterly, this more defensive and conservative positioning has meant that BRCI struggled to keep up with the benchmark over the course of 2016 and 2017 in what were more positive market environments.
BRCI has had a very strong start to the new year, having kept pace with the reference index in the rebound, and outperformed global equities. As the graph below illustrates, the managers outperformed handsomely last year up until September 2018 through their exposure to E&P oil stocks and having exposure to the larger, diversified miners. However, fears of a slow-down in China and a trade war meant that the relative gains were given up in the last quarter of last year.
One of the key attractions for BRCI is its high dividend yield, which suits the underlying mining and energy sector exposure because of their ability to generate very significant amounts of cash. The current dividend of 4p per year (paid quarterly) is equivalent to a yield on the share price at the time of writing of 5.6%, which is very much higher than most other generalist equity income funds. In the most recent annual report, the board has reaffirmed its commitment to a 4p dividend for the financial year ending 30th November 2019. The board also stated that it will look to protect any future shortfall in earnings with revenue or capital reserves, which in our mind indicates that the dividend yield of 5.7% looks relatively secure. At this level, the trust yields considerably more than most other areas of the market.
This commitment is important, within the context that the board had to reduce the dividend to the current level (from 6p paid in 2015). Up until 2016, BRCI had a good track record of dividend growth, but given the widespread dividend cuts that affected the mining (and to a lesser extent) energy sectors, the board reduced its dividend target to 5p in 2016 and to 4p for 2017, with 1p per share paid quarterly.
The board’s reaffirmation that 4p remains the target gives confidence that this will be the nadir for the dividend level. During the 2018 financial year, the revenue return per share declined 9.7%, which resulted in earnings of 4.37p – with the dividend covered. We calculate that revenue reserves stand at 0.6X the current 4p annual dividends.
Historically, when market conditions allowed, the managers have opportunistically used option writing to boost income. We note that during 2015 and 2016, option writing accounted for more than 50% of the trust’s income, but this has come back as a proportion as market volatility has retreated. In the recently published annual report, the board has stated that it would be happy to see the managers employ less option writing going forward, and that it will cover any earnings shortfall with revenue or capital reserves. The team retain the potential to employ the strategy again - our observation being that option writing is expected to generate good returns when volatility is high – exactly when dividends from the underlying companies will be less certain. As such, it can be considered something of an income hedge for more difficult market conditions, should the managers choose to employ it.
As we discuss in the portfolio section, the trust remains exposed to some of the largest and arguably more defensive global companies in the mining and energy sectors, which are all generating enormous amounts of cash thanks to lower cap-ex and their very low production costs. Given that they have largely moved to payout ratios based on profitability, over the long run dividends should be more sustainable. Almost all of the portfolio companies pay dividends in dollars, meaning that even with the recent strength in sterling, it remains weaker than when we last wrote on BRCI in August when we noted that cable was 1.32 (1.30 at the time of writing).
At this level the trust yields considerably more than most other areas of the market (Global Equity Income investment trusts yield 4.1% (source: JPM Cazenove)). With the managers continuing to believe that many of their investee companies in both the energy and mining sectors are committed to returning cash to shareholders, and remaining disciplined as regards capital spending decisions, there are grounds for continued optimism for 2019.
Olivia Markham and Tom Holl have managed the trust since January 2014 and both are members of the Natural Resources team within the Fundamental Equity division of BlackRock's Alpha Strategies Group. The duo manage a variety of natural resources strategies for the group, with Oliva co-managing BlackRock World Mining and Tom running various open-ended funds such as BlackRock Gold & General and BlackRock Natural Resources Growth & Income.
Given the size of BlackRock as a group, Olivia and Tom have a huge amount of support and access to a wide range of resources. Not only do they work closely with the rest of the natural resources team and are supported by BlackRock’s sizeable risk management team, the managers note that one of the major benefits has been working alongside the variety of other equity and credit teams – with Tom and Olivia regularly attending company meetings with members of different desks from around the firm.
As the graph below shows, BRCI has consistently traded at a significant premium to its peers in the Commodities and Natural Resources investment trust sector. The main reason for this is clearly the focus on yield, but also the board’s activities which have kept a fairly tight control of the discount. The board has historically been fairly active, both on the issuance and buyback front. Latterly, it has been buying back shares – the most recent of which was on 22nd October 2018, when (by our calculations) it purchased shares on an 8.2% discount. Over the last financial year, the average buyback level was a discount of 6.6%.
Historically BlackRock Commodities Income has traded on a premium to NAV. However, the lowered dividend target for 2017 (announced in mid-2016, and clearly observable in the chart below) hit sentiment, which has weighed for much of the time since with the discount widening out. It hasn’t all been one-way traffic however, and 2018 saw a spike in enthusiasm, with the board issuing a small number of shares again in March on a premium of 2.2%.
The shares trade at a discount of 5.3% at the time of writing. Last month (December 2018), we reviewed the investment trust universe and used a proprietary technique to identify trusts which have rarely looked cheaper (to their own history) in discount terms. BRCI was one of them, and as the graph below shows, on a discount basis the trust has rarely looked cheaper – being well into the bottom decile of cheapness.
BRCI – DISTRIBUTION OF DISCOUNT OVER TEN YEARS
We continue to observe that there are relatively few trusts which offer an above average yield but that trade on a discount – especially one that is well covered by revenue reserves and has the potential to grow over the coming years. Certainly, if one believes the managers’ central thesis for more discipline from the managements of the portfolio companies, and that shareholder returns will continue to be prioritised over volume growth, then the trust’s discount offers an attractive entry point.
Historically, the board has had the discretion to make semi-annual tender offers at the prevailing NAV, less 2%, for up to 20% of the issued share capital in August and February of each year. In the recently published annual results, the board has stated that it sees buybacks as more appropriate and so will not be seeking authority to make semi-annual tenders henceforth.
The trust’s management fee is equal to 0.95% of gross assets p.a. and will reduce to 0.9% p.a. for gross assets in excess of £250m. The trust’s gross assets are currently c £92m. The fee is levied quarterly, based on the gross assets on the last day of each quarter, and is charged 25% to the revenue account and 75% to the capital account. Overall, BlackRock Commodities Income has an ongoing charge of 1.39% (financial year ending Nov 18). There is no performance fee.