Investment spotlight: Patient capital

Decline in real income

The world economy is not deglobalising, although the rapid growth of trade, relative to output, has slowed. Emerging and developing countries have not only become important in world output, they have become increasingly important in population. Change in relative economic power, and shifts in the comparative size of populations shape our world.

By 2050, the UN reckons that sub-Saharan Africa’s share of the global population will be almost as large as that of all the high-income countries in 1950, but much poorer. The immigration crisis of the EU will not end any time soon. These economic convergence and shifts in population are central elements in the big economic picture. 

Change and the US

Technological change brought about the internet. This merging of data processing and communication became the most important technology of our era aided by the collapse of the relative cost of semiconductors. But the sources of dynamism – technological change, productivity growth and global trade – are slowing and no one knows why. 

This global technological frontier has been driven by the US ever since the late 19th century. But Robert Gordon, a professor of social sciences at Northwestern University, argues that the US economy has never matched the outstanding productivity it achieved between 1920 and 1970. 

One result, which has been powerfully reinforced by the 2007/08 collapses of banking systems, has been real income stagnation in Western high-income countries. 

Rising populist pressure across these economies makes managing these shifts far more difficult. 

The McKinsey Global Institute calculates that up to two-thirds of the populations of many rich countries suffered flat or falling real incomes between 2005 and 2014, so it is little wonder then that so many voters are grumpy. They are neither used to this, nor wish to become used to it.

Politics and safety

This is not an attractive business environment in which to invest, either for growth or productivity. Then factor in the politics of President Trump and Brexit, and the desire of most investors is to take no risk. 

But as Jeremy Grantham, founder of GMO, recently wrote: “Contrary to theory, the market price-earnings level does not primarily reflect future prospects, but current conditions. The variables it weights heavily are not academically or economically correct, but those that make investors feel comfortable. 

“High profit margins and stable, low inflation dominate this feel-good list, with stability of GDP growth (as opposed to actual growth) coming a distant third. 

“Investors’ extreme preference for comfort – as with human nature – has never changed. 

“The ebb and flow of these variables explains previous market peaks and troughs. These comfort factors, for example, have been at an extremely high average level for 20 years (as have price-earnings ratios) and remain so today, so today’s high-priced market is the completely usual response from investors. 

“Any shift back to a lower price-earnings regime must therefore be accompanied by a major sustained fall in margins or a sustained rise in inflation (or both). And, yes, I do believe these comfort variables will move to be less favourable.” 

Investment trust choices for dangerous markets

It was against this background that I asked Winterflood Securities to design a portfolio of six to 10 investment trusts to be held for at least 10 years, suitable as savings for retirement, a pension plan, or similar. The overall purpose is income generation over the decade, with accompanying capital growth. 

I was expecting a good mixture of dividend heroes, plus some future stars within the technology, medical, retailing and electrical storage areas. Asian diversification was also likely to be offered, but not too much exposure to UK/Europe because of the mostly unappreciated Brexit threats.

Emma Bird, a research analyst at Winterflood, summarised this portfolio of 10 investment trusts as having been constructed “with an aim to provide a combination of long-term capital growth and income through investment in defensive and more growth-oriented funds”.

Table 1 above outlines the broker’s choices, which can be broken down into the following categories:

Satisfying government needs for non-tax capital

HICL Infrastructure and John Laing Environmental Assets offer attractive yields, inflation-linked cash flows and growth profiles with a low correlation to equity. Governments guarantee income, and this is why HM Treasury likes investment trusts. 

HICL’s recent acquisition of Affinity Water, which is an operating company, albeit a regulated utility, underlines the changes in the fund’s portfolio, which have been driven by competition for infrastructure assets and the limited supply of public private partnership (PPP)projects in the UK. 

Following other acquisitions during the latest financial year, the fund also now has 10 per cent of its portfolio invested in demand-based assets through three toll roads. In Winterflood’s view, the increased correlation to inflation brought by new investments is positive in the current environment.

Diversifying into the wider world

RIT Capital Partners and Personal Assets are able to invest in a range of global asset classes. Both aim to protect the value of shareholders’ funds or, in the words of Personal Assets, “to protect and increase [in that order] the value of shareholders’ funds over the long term”. Their performance generally lags strong market rallies, but both have demonstrated their ability to outperform in falling markets.

JPMorgan Global Convertibles Income should provide an element of participation in equity upside, with a degree of downside protection. The fund represents an attractive option for investors seeking an above-market yield with cautious exposure to equity markets. 

The trust focuses solely on investing in convertible bonds, so is unique within the investment trust sector. The fund is largely invested in bond-like and balanced convertibles, which offer higher yields with lower equity sensitivity, and should therefore prove to be defensive during an equity market sell-off.

Because of the current uncertainty surrounding Brexit, Perpetual Income & Growth is the only UK-focused pure equity fund. However, the fund has a strong long-term performance record under Mark Barnett’s management, outperforming the FTSE All-Share and its peer group over five and 10 years. The dividend yield of 3.4 per cent is attractive, and the fund has a long-term record of dividend growth. 

Winterflood views Caledonia, Monks, Aberdeen Asian Income and Worldwide Healthcare as offering significant long-term growth potential. 

Worldwide Healthcare provides more diversified and lower volatility exposure to the sector than its sister fund, The Biotech Growth Trust, and has a strong performance record in absolute and relative terms. The broker believes the fund benefits greatly from the large specialist team of more than 80 investment, medical and scientific professionals at OrbiMed. 

Taking advantage of short-sightedness

Aberdeen Asian Income benefits from Aberdeen’s significant resources and experienced team, and offers an attractive yield of 4.4 per cent, with the dividend increased every year since its launch, apart from in 2008 when it was maintained. 

In addition, the dividend has been fully covered each year, enabling contributions to the revenue reserve, which will be able to support the dividend if needed. 

Following a period of disappointing performance, the fund has been de-rated from trading at a premium in mid-2015 to its current discount of 8 per cent. This offers a considerable value opportunity, in Winterflood’s opinion, as the fund’s two closest peers: Henderson Far East Income and Schroder Oriental Income are trading on a premium at present. 

Purchase commission rates can be avoided with those trusts, such as Personal Assets, that make a market in their own shares as part of a discount control mechanism. In addition, investors will need to pay stamp duty on all UK-incorporated investment trusts, just like every other UK share. 

But JPMorgan Global Convertibles Income and HICL Infrastructure are incorporated in Guernsey, and Aberdeen Asian Income is incorporated in Jersey, so are not subject to stamp duty.