Securities Trust of Scotland (STS) is a broadly diversified global equity income portfolio that aims to deliver a rising level of income and long-term capital growth from a diversified portfolio of equities.
The trust has undergone something of a transformation in recent years, implementing a new progressive dividend policy which allows income to be drawn from capital, and appointing a new manager, ex-Sarasin star Mark Whitehead, who joined Martin Currie as head of income in 2016.
Since he arrived, Mark has built a strong team around himself – including the trust’s former lead manager Alan Porter – and put in place a rigorous investment process which sees potential investments put through a series of ‘tests’ designed to show how they will behave in unpredictable scenarios.
Mark employs an unconstrained, bottom-up approach to stock selection, starting with an investable universe of around 3,000 stocks, paying particular attention to credit analysis and stress testing to identify companies that can demonstrate strong free cashflow, which they believe in turn translates to sustainable dividend growth.
Since Mark’s appointment in 2016, the trust has produced returns largely in line with its peer group benchmark, up until the recent correction which saw the trust lag for stock-specific reasons. The trust offers a solid yield of 3.8% - putting it ahead of the majority of its peers in the AIC Global Equity Income sector in income terms.
At the time of writing, the trust is trading on a discount of -6.53%, well beyond the weighted average discount for the sector (-3.3%), where the large majority of other trusts trade close to par or at a premium, including some which have only marginally outperformed STS over recent years.
It is early to judge performance given Mark’s appointment two and a half years ago and the portfolio overhaul which accompanied it, but the trust has broadly kept pace with its peers (up until the recent correction). Further - on closer examination – it is clear that the range of returns delivered by the trusts within the AIC Global Equity Income sector is narrow; with only 3% between STS and the second best performing trust in the sector over one year. With this in mind, the current discount of -6.5% is attractive when other trusts in the sector – trusts which STS has outperformed – are trading on a premium. We note that JPMorgan Cazenove is overweight toward the trust in its recommendations.
Discount opportunity aside, we believe that the investment process is a key stand out for the trust. The focuses on credit analysis, stress testing and, in particular, ESG factors help to identify undervalued opportunities that other trusts may not pick up on.
Alongside this, the trust offers a robust yield and the board has shown a clear willingness to stick to the progressive dividend policy, after paying a small portion from capital this year. Additionally, in the current volatile environment, the trust should benefit from the option writing facility.
We like the focus on free cash flow and dependable earnings, and believe the trust has the capability to offer sustainable, long term dividends.
BULL AND BEAR
|Rigorous and unique investment process
||Expensive OCF relative to peers
||Has not produced a particularly eye-catching performance relative to peers
|Utilises the structural benefits of closed ended funds
The trust applies an unconstrained approach, looking to identify companies that have attractive growth prospects and high-quality earnings. The team begin their investment process with a potential universe of close to 3,000 stocks, and each idea is put through a transparent and replicable process. After an initial screen, the individual analyst pitches the potential idea to the rest of the team, and if deemed appropriate, the team undertakes bottom up company analysis and financial modelling. They look to uncover the prospects for dividend growth through assessing the sustainability of earnings and cash flow over the long term. To finalise the process the investment proposition is put to another robust discussion, which can include other teams from across the Martin Currie group.
Noteworthy in the process is the credit analysis and stress testing of the company – effectively ‘war gaming’ the potential investment for different environments. Mark places a great emphasis on this stage of the process, and sees it as a key differentiator relative to the peer group. In practice, the team examines the structure of the company and assesses how it might fair in differing conditions, particularly in terms of companies that are considered cyclical. Mark previously cited Inmarsat, a mobile satellite and communications business, as an example of where this has worked well in the past. Inmarsat had illustrated strong growth prospects, however capex had started to increase dramatically. Mark noticed the company was increasingly reliant on debt and started to see the level of dividend growth as unsustainable. Despite promises from the management team at Inmarsat that capex was increasing at an appropriate level, the team sold its position. As anticipated, Inmarsat was eventually required to cut its dividend.
The team at Securities Trust of Scotland also places a strong emphasis on ESG factors and Martin Currie is a signatory of the UN PRI (Principles for Responsible Investment). It has also been awarded the highest possible rating for its activities by the PRI over several years. Research shows that companies with stronger governance and sustainability practices tend to demonstrate better operational performance, which ultimately translates into cash flows and dividends.
The trust is focused, with a portfolio of 45 holdings, but remains well diversified in the sense that the top ten holdings only account for 39% of the portfolio. The United States forms the largest single regional weighting (54.8%), while Europe (44.9%, including the UK) forms the next significant weighting. The manager has also reduced his holdings in emerging markets over 2018, which proved to be a good decision as the dollar has gone from strength to strength.
The regional weightings are reflective of the manager's active approach to stock picking, and have varied significantly since Mark's appointment in 2015. Developed Europe reached lows of 19% in early 2017 (according to data from Morningstar), while the allocation to North America reached close to 60%. However, since then exposure to the US equity market has been reduced, largely due to valuations, and the proceeds have been re-invested into Asia, Canada and Europe. In the case of the former they believe that, although there are some significant headwinds facing Europe, the economic recovery is less mature than that of the US, leaving a longer runway for improvement.
In sectoral terms the portfolio is also broadly diversified. Financials make up the largest proportion of the portfolio (18.7%), followed by consumer staples (13.9%) and information technology (12.7%). These in turn are followed closely by industrials (12.6%) and then healthcare (11.9%). The manager has reduced his exposure to financials in recent times, as he concerned on the outlook for growth as we close in on the end of the current economic cycle. Furthermore, within the US they are not seeing the lending growth of the banks come through at a rate they once had hoped. When we last covered the trust in October, the second and third largest exposures were to industrials and materials, however this has continued to be reduced due to their cyclical nature, and the manager moving to a more defensive position. As such, staples and communication services have continued to be added to.
Mark recognises that, over the past two or three years, income as a style has trailed the technology-led bull market. However, the new year has brought with it new life in the income sphere, and the team are starting to see improving prospects for dividend-producing sectors. Healthcare is an example of a sector that excites Mark, and over the coming year he anticipates solid dividend growth. In comparison, Mark will be keeping a close eye on the banking sector, which he believes needs to be approached more cautiously than in previous years.
The team continue to recognise political risks across the globe, mainly the timing and rate of rises from the Federal Reserve. Higher rates will impact some of the more expensive equities as well as the associated higher borrowing costs. As such, they expect to see volatility persisting in equity markets for some time to come.
The use of gearing is an important income generating aspect of the trust. The manager consistently employs double digit levels, and is able to gear up to as much of 20% of the trust’s NAV. Over the past year the trust has averaged 13.4% net gearing, which crept up to highs of over 15%, however this has been reduced in the new year, to around 14%. This is largely similar to the rest of the sector where the weighted average is 11%.
For the majority of the time since Mark’s appointment in May 2016, the trust has produced returns largely in line with its peer group benchmark. However, the recent correction saw the trust’s performance diverge from the benchmark, hurting what would otherwise be a decent year relative to peers and the benchmark MSCI World. December saw the trust lose 7.2%, in which the MSCI ACWI ended down 6.8% (in sterling terms) over the month. However, much of this was due to stock-specific factors. For example, Philip Morris International struggled as the market viewed it to be dependent on heated tobacco, a worry intensified due to Altria’s purchase of a 35% stake in July.
Over the two-and-a-half-year period that Mark has been at the helm, the trust has delivered an NAV return of 26.7%, in comparison to the Morningstar IT Global Equity Income peer group (37.5%). Relative to the MSCI World Index, the trust has also lagged, however, this would likely be due to the relative underweight position to the US and also technology, which has been the standout country in terms of performance over the past few years. Additionally, many of the stocks that have delivered the highest returns have been non-dividend paying growth stocks, which would not be suitable for Mark’s investment objective.
Over 2018, the trust has outperformed the Morningstar IT Global Equity Income peer group – albeit against a backdrop of negative returns across the sector. Unsurprisingly the strongest performing sector in the portfolio over the past 12-months (to the most recent interim report - September) has been information technology, contributing 4%. In particular, Microsoft and Apple stood out. Energy and materials also delivered reasonable returns; 1.6% and 1.1% respectively. The largest detractors were consumer discretionary (0.2%), telecommunications (0.4%) and consumer staples (0.6%).
The trust has a progressive dividend policy, aiming to offer investors inflation-beating dividend growth alongside capital appreciation. In 2016, the board changed the dividend policy, repositioning of the portfolio towards stocks with stronger cashflow and growth characteristics. As such, the trust has considerably increased its dividend in recent times and the board has recently announced their second interim dividend of 1.45p which will be paid on 18 January. The annualised dividend represents a yield of 3.5%.
For the year ending 21 March 2018, the trust paid a total dividend of 6.1p, an increase of 2.5% from the year before. Of this, 0.27p was paid from capital in the fourth interim. This was the first time that this facility was used, and the board see it as a positive step, helping to give the manager more flexibility to hold stocks with higher growth potential but slightly lower yields.
The trust also uses derivatives to support income generation. They ensure to only sell put options on stocks that have been approved for this by Martin Currie’s internal specialist team, and only sell call options that are owned within the portfolio (covered calls). This also helps to improve the income generation of the trust, particularly in the recent volatile conditions.
Mark Whitehead took control of the trust in May 2016, having joined Martin Currie as head of equity income in late 2015. Mark, who has 20 years’ experience, leads a team of five– one of whom is former lead manager Alan Porter, who remains heavily involved in the day-to-day management of the fund.
The team is exclusively focused on income and works in a collaborative fashion, discussing new stock ideas early in the development of an investment case to avoid the temptation of a ‘big reveal’ approach. The team sits together and meets formally regularly and has access to a ‘cross floor’ meeting for the whole Martin Currie investment team, which takes place every day.
At Sarasin, Mark had a good performance record, with the Sarasin Global Higher Dividend Fund outperforming the MSCI World High Dividend Yield index under his eight-year tenure. His time as manager of the Sarasin Global Dividend Fund was much shorter at less than two years but here, too, he outperformed the index.
Securities Trust of Scotland is trading on a discount of -6.5% as at 15th January 2019, considerably narrower than when we last covered the trust in November (-8.4%) and the one-year average of 6.9%. The average discount within the AIC Global Equity Income sector is +3.3% and with only a 6% difference between STS and the best performing trust in the sector over one year, we feel the current discount has a good chance of continuing to narrow. This is especially true when one considers that other trusts in the sector – trusts which STS is in line with performance-wise – are trading on a premium.
In an attempt to limit discount volatility, the managers have been buying back shares, and over 2018 c.7.41m shares were added to treasury. Additionally, the board has been attempting to manage the discount through increased marketing for the trust.
Shareholders have option to redeem their shares if the average discount to ex-income NAV is more than 7.5% over the 12 weeks before the financial year-end, which is on the 31 March.
Last year, the board announced a change in the management fee for the trust. With effect from 1 April 18, a fee of 0.6% was applied to assets up to the value of £200m and at an annual rate of 0.4% of for assets above £200m.
As of the end of the most recent interim report (to the end September 2018) the OCF was 0.9%, 0.1% lower than in 2017. This makes the trust more expensive than some peers, however, the board does not charge a performance fee like some do. In comparison to the open-ended sector, the trust is marginally cheaper than the average annual report ongoing charge of 0.95% (Morningstar).