North American Income Trust

A differentiated source of equity income from a focused portfolio of US equities…

Disclosure – Non-substantive Research

This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. With this commentary, Kepler Partners LLP does not intend to influence your investment firm's behaviour. 

North American Income Trust

Summary

The North American Income Trust (NAIT) is a £427m investment trust which aims to generate a steady, growing income and capital growth over the long term. Managed by Ralph Bassett and Francis (Fran) Radano, the trust has seen its discount narrow sharply this year as it moved to split stock five-for-one – making it easier for small investors to buy.

Offering a yield of 2.8% the trust is one of two US-focused trusts which aim to generate income, achieving that via a focused portfolio of equities and bonds, mainly investing in large well-established businesses with strong records of capital deployment.

In addition to equities and bonds the managers also use derivatives at the margin to boost the portfolio’s income. The managers have grown the dividend by 9% per annum over the past five years, while at the same time building a significant revenue reserve where, five years ago, there was virtually none.

In performance terms the trust has delivered strong returns since Ralph and Francis took over in June 2015, generating NAV total returns of 79.6% against a rise of 61.7% in the Russell 1000 Value index. Shareholders have benefited further from a closing discount which means in share price terms the trust is up 104.6% over the same period.

Since the early summer 2019, NAIT has been trading at a premium to NAV, following a steady re-rating that it has enjoyed since the start of the year. The trust is now issuing shares, which we would argue is a positive development for all shareholders. Given the tiered management fee, the OCF should start to reduce meaningfully if share issuance continues.

Kepler View

NAIT is an interesting diversifier for investors seeking an income who would like to find it outside the ‘usual suspects’ of UK equity income. Alongside this, it has outperformed the benchmark handsomely since the managers took over the mandate.

Given the highly concentrated nature of UK dividends – with a small number of companies appearing in many of the UK’s most popular UK equity income funds – we think NAIT makes sense for UK investors seeking new sources of income.

In our view the managers have done a good job building up a significant revenue reserve where there was none five years ago, all while delivering strong dividend growth. This bolsters prospects for a stable or growing dividend going forward, in our view. In this context, the share price re-rating NAIT has experienced is justified, and shareholders stand to benefit (assuming share issuance continues) from a lower OCF as the trust grows.

bull Bear
An excellent diversifier for UK income investors The yield is relatively low compared to a UK-focused equity income fund
Strong interest from retail buyers should continue to support the share price rating US large caps are at record valuations, so there could be some downside here
Impressive 9% annualised increase in dividends over the past five years Dollar weakness could negatively affect ability to grow dividends further

Portfolio

The North American Income Trust (NAIT) aims to generate an above-average dividend income and long-term capital growth via a concentrated portfolio. Currently the portfolio comprises 40 equities and nine bond positions; although the vast majority of investments (98% by value) is invested in equities.

This level of concentration is a typical Aberdeen construct, and follows the logic that every holding can make a difference to the portfolio, but still leaving room to ensure that the manager can achieve diversification.

When it comes to stock selection Fran Radano, who runs the fund alongside Ralph Bassett, told us the managers place a heavy emphasis on cash generation, and the majority of the companies in which the trust invests are large and well established – with a market capitalisation in excess of $10bn – though a few are in single digit billions. We reproduce the top ten holdings in the table below.

top ten holdings

holding
%
Citigroup
4.7
Philip Morris
4.6
Chevron
4.3
Bristol-Myers
4.3
BB&T
4.0
Verizon Communications
3.4
Cisco Systems
3.1
Coca Cola
3.1
Gaming & Leisure Properties
3.0
Regions Financial
3.0
Total
37.5

Source: Aberdeen Standard, as at 31/10/19

Although the trust is benchmarked against the Russell 1000 Value index, Fran is free to go ‘off menu’ and as a result the trust has a high active share (a measure which shows the extent to which a portfolio diverges from its benchmark). Asset allocation is the result of stock selection, and when choosing potential investments a primary concern is the yield that they generate. Potential investments must generally yield in excess of 2.7% – ahead of the 2.5% yield from the index. Within this, the managers look for companies which are growing their dividends progressively, and can demonstrate disciplined use of capital.

The managers dislike businesses which – rather than reinvesting excess cash or paying it out via dividends – use it to fund undisciplined project spend, or overly ambitious acquisitions to achieve scale that they would prefer to be achieved organically.

The trust has a reasonably high but not excessive turnover of stock, at 20-40% per annum, and Fran puts this down to the focus which he places on yield. He cites Microsoft as an example of a company the trust previously owned which has since been sold because – while it remains a highly successful business – the growth in its share price has seen its multiple double and its yield fall from nearly 4% to 1.5%.

Aside from yield, Fran tells us the team also tends to pare back holdings which have done particularly well relative to the market; he cites semiconductor giant Texas Instruments, which had been performing well on the back of a good environment for cyclicals. In October, it sold off 8% – after the managers had halved their stake.

The final element of the portfolio is a small sleeve of options (derivatives) which the managers use selectively: either writing call options on stocks (to sell) that the trust already owns, if they are trading at the higher end of a fair valuation range; or writing put options requiring it to buy the stock at a particular price at a later date. Clearly if the price of stock at the time of exercise is higher than the strike price of the put, the manager will not be asked to buy the stock at the strike price, but has still generated income from writing the option. Similarly ,with a call option, if the price in the market is below the strike price the trust keeps the premium and will not be asked to sell the stock. Fran is keen to stress that, while these options have contributed to the trust’s yield, they are used selectively, and most of the trust’s holding are not volatile enough for these options to be applied.

NAIT invests a small portion of its portfolio in corporate bonds. This allocation has come down in recent years, but continues to provide a decent yield. Although making up only 2.3% of the portfolio at the end of July 2019 (the date of the latest interim report), the bonds provided 3.2% of its income. Bonds and options are, however, both regarded as secondary sources of income to dividends.

As one might expect, NAIT is overweight (relative to the Russell 1000 Value benchmark) in the traditionally higher-yielding sectors of financials, healthcare, energy, consumer staples and materials; while being lighter on the more growth-oriented IT and consumer discretionary sectors which have tended to lead the market in recent years.

Sector allocations

Source: Aberdeen Standard, as at 31/10/19

Gearing

The board believes that a modest level of structural gearing is of benefit to shareholders, and gearing (borrowing used to fund investments) is available to the trust in the form of a £75m flexible debt facility, of which $50m is drawn down. Net gearing has fallen since the start of the year and currently sits at roughly net zero, thanks partly to the company paying down debt, and partly to it writing more options and holding cash as collateral.

net gearing

Source: Morningstar

Returns

Originally a tracker fund, the North American Income Trust was born in 2013 after the conversion of what was previously the Edinburgh US Tracker. Over five years to 21 November 2019 the trust has delivered strong NAV total returns of 81.5% in absolute terms, outperforming the benchmark Russell 1000 Value index (which was up 68.2%) and the average trust in the Morningstar Investment Trust North America peer group (68.6%) over the same period.

Since Ralph and Francis took over in June 2015, replacing former manager Paul Atkinson, the trust has generated NAV total returns of 79.6% against a rise of 61.7% in the Russell 1000 Value index. Shareholders have benefited further from a closing discount, which means in share price terms the trust is up 104.6% over the same period.

Five-year Nav performance

Source: Morningstar

NAIT outperformed the value index each year between 2015 and 2018, but has underperformed in 2019 to date. In 2016, an overweight position in materials and financials helped the outperformance, while stock selection was also strong. In 2017, it was primarily stock selection which contributed to excess returns, mainly in industrials, financials and consumer discretionary. In 2018 it was stock selection again, mainly in IT, materials, financials and industrials. The overweight to materials and utilities were the major detractors.

In 2019 so far, the trust’s underperformance has mainly come from one poor period in July, when the market sold off rapidly and the trust did worse than the index. In this period, materials, energy and financials were the sectors that performed relatively badly, and these were (and still are) overweights for the trust, being traditionally higher-yielding sectors.

calendar-year returns

Source: Morningstar

Dividend

NAIT pays dividends quarterly and currently yields 2.8%. Dividends have been fully covered by underlying portfolio income (including option writing activity). Indeed, the managers have made excellent progress in building up a significant retained revenue reserve – almost a full year’s worth of dividends. NAIT pursues a progressive dividend policy and has increased its annual payout by 9% a year over the past five years.

dividends per share

Source: Aberdeen Standard Investments


Management

The trust is managed by Ralph Bassett, deputy head of North American equities, and senior investment manager Francis Radano – both of whom are based in Aberdeen’s New York office. The pair took over after the departure of Paul Atkinson in June 2015 and they work as part of a large team with significant resources, bolstered in recent years by the merger of Aberdeen and Standard Life.

Discount

Over the last three years NAIT has traded in a range of 4-9% below par, with the occasional spike into double figures. More recently however, the discount has narrowed sharply and during the course of this year it has switched to a premium of 0.73%, tighter than the average AIC North America trust.

In addition to a solid performance versus the benchmark, the trust’s income provision is clearly an attractive feature, especially given that it is differentiated from the usual UK equity income sources. The trust’s inclusion in retail investor platform ‘preferred lists’ – such as Interactive Investor’s ‘Super 60’ – is also likely to have had an impact.

As a result of the discount having now closed, and with the shares now trading at a premium, the trust has been able to issue new shares for the first time since the new strategy was adopted. NAIT has issued 600,000 new shares at a modest premium in September and October this year, which is good news for existing shareholders given that at the margin it will bring down the OCF. This is because charges are now spread over a wider asset base, alongside the fact that the trust’s net assets of £423m are well into the second (lower) tier of the management fee – please see Charges section.

discount

Source: Morningstar

Charges

The trust has an ongoing charge of 0.95%, making it the second cheapest of five trusts in the AIC North America sector. There is an annual management charge of 0.75% on the first £350m of net assets and 0.6% up to £500m. With net assets of £423m, any further growth in the trust (organically, or through share issuance) should start to materially reduce the OCF. Should the trust grow beyond £500m, the marginal net assets will be charged at just 0.5%. The Key Information Document Reduction In Yield figure is 1.35%, which compares to a weighted AIC North America sector average of 1.02%, although we note that methodologies can vary.

ESG

The managers subscribe to ASI’s philosophy that ESG factors can have a material impact on the future financial performance of companies. Assessment of ESG risks is integrated into the team’s stock analysis, and is a key component of the overall quality assessment applied to the stocks held in the trust. Where risks are identified, significant emphasis is given to engaging with holdings to promote best practice, improve reporting, and proactively invest to reduce tail risks.

Kepler Partners LLP considers this commentary to be a minor non-monetary benefit, as it:

1. Is intended to enhance the quality of service provided to you by us and is generic in nature;

2. Consists of short-term market commentary on the latest economic statistics and/or company results and/or information on upcoming releases or events;

3. Contains a brief summary of the author’s own opinion on such information;

4. Is not substantiated nor does it include any substantive analysis;

5. Reiterates the Kepler Partner LLP’s view on an existing recommendation or substantive research material; and/or

6. Is unlikely to impair your investment firm's compliance duty to act in the best interest of your client.

This report has been issued by Kepler Partners LLP for communication only to eligible counterparties and professional clients as defined by the Financial Conduct Authority.  Its contents may not be suitable for and are not to be communicated to or be relied on by retail clients. It is not an indication as to the suitability or appropriateness of investing in the security or securities discussed.

Past performance is not a reliable indicator of future results. The value of investments can fall as well as rise and you may get back less than you invested when you decide to sell your investments. It is strongly recommended that Independent financial advice should be taken before entering into any financial transaction.

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