Analyst's Report

Slow but steady progress ahead

The outlook for investment trusts in 2010

By Alan Brierley, Investment trust analyst, Collins Stewart

• Introduction
• Interest rates to remain low?
• Benefiting from strong dividend growth

 Introduction

Although it seemed highly unlikely at the beginning of March, 2009 looks like being a good year for the Investment Trust sector, which has delivered strong absolute and relative gains for shareholders.

The Investment Trust sector has fully participated in the recovery in global stock markets, which have just enjoyed their most powerful rally in history.

Within the closed-end sector, good asset performance and a recovery in general confidence levels have fuelled a re-rating from the distressed discount levels that were prevalent at the beginning of the year. The average sector discount is now 11% compared to 22% at the start of this year and in line with its 10-year average of 10%*.

In the past few months, the authorities appear to have been successful in preventing the global economy from sliding from a deep recession into a depression. Stock markets have reacted positively to a flow of less-bad news and have discounted a return to sustainable economic growth. That said, many structural problems remain (most ominously in developed economies) and we remain concerned about rising unemployment levels, high levels of debt in both the corporate and consumer sectors, the lack of any meaningful recovery in consumer spending (which represents a significant proportion of GDP), and the parlous state of the commercial and residential property markets. Meanwhile, the execution of the exit strategy from monetary easing and massive fiscal stimulus also poses significant risks for both global economies and stock markets.

Only time will tell what the implications will be of addressing the largest asset bubble in history by effectively inflating another but we are now very much in uncharted waters and the compass is broken. Looking forward to 2010, we see a much more challenging environment for investors although given the amount of liquidity being pumped into the system; one should not underestimate the ability of risk assets to move much higher. However, although the party is now in full swing, we recommend dancing near the door.

Source: Fundamental Data, 23 November 2009

 Interest rates to remain low?

Although the most likely consequence of the recent actions by the authorities is the re-emergence of inflation, we do not see this as an issue over the next few quarters and accordingly UK savers may continue to be faced with interest rates close to zero. The UK Growth and Income sector has traditionally given investors a low risk exposure to the UK equity market, and an attractive dividend yield. At this time, the sector offers an attractive yield, the current weighted average is 5.3% compared to the yield on the FTSE All-Share Index of 3.3%*. However, in the past couple of years, the capital performance has been disappointing; firstly the sector had a significant exposure to the UK banking sector and then more recently it has been underweight in those more economically sensitive sectors that have performed strongest in the recovery phase.

Moving forward, we believe there is undoubted potential for a rotation in market leadership. Following a prolonged period of mismanagement, the UK economy is at risk of several years of sub-trend growth In this environment, those cyclical companies that have performed well in recent months could be vulnerable. Meanwhile, this backdrop could see those defensive sectors, which have the ability to deliver sustainable earnings and dividend growth, begin to outperform. Neil Woodford, one of the UK’s leading investment managers, recently drew a parallel with experiences at the end of the 1990s when performance in the UK market was similarly polarised. He believes that somewhat paradoxically, those companies with the greatest upside potential namely high quality defensives, are now trading at a historically wide discount to the underlying market.

 Benefiting from strong dividend growth

Although the UK equity market has traditionally had one of the highest dividend yields, improved capital discipline in other markets has seen strong dividend growth in recent years. A good way of achieving exposure to these overseas markets is Murray International. Manager, Bruce Stout has transformed the fortunes of this company over the past five years. Bruce was the first manager we encountered to warn about problems within the Western banking system and his views proved to be prophetic.

Ominously he expects problems in the UK and US to take several years to work through; since assuming managerial responsibility in 2004, his exposure to these two countries has fallen from 57% to 23% of NAV**. Indeed, while the UK weighting is now 13%, we would note that most of this is represented by multinational companies that are listed in the UK. The strategy is to focus on those companies that can deliver high quality corporate earnings and well funded dividends. In his latest factsheet, Bruce warned that investors resolve is about to be tested by what remains a very fragile economic backdrop.

Over the past 10 years, global emerging markets have made significant progress. Although the debate continues to rage over whether emerging economies can de-couple, we would note that over the past eight years emerging stock markets have outperformed developed markets by a staggering 15% each year*. With the West facing deeply embedded structural problems, emerging markets appear to be in a much stronger macroeconomic and financial position. We would highlight that balance sheets, at the corporate and consumer level, are in much better shape while incomes are rising and savings rates are high.

The investment trust sector has made great strides forward over the past ten years and is now well placed to continue to add long-term value for its investors. Finally, we would note that corporate governance has been strengthened while discount volatility has been reduced though a number of initiatives.

* Fundamental Data 23 November 2009
** Aberdeen Asset Managers 30 November 2009