CHANGING TIMES
for high income
As investors have become more risk averse and require greater transparency in their search for income, investment managers have had to adapt to changing times, says Aberdeen Asset Management’s Ed Beal.
There’s a Chinese proverb that says, “the wise adapt themselves to circumstances, like water moulds itself to the pitcher”. Over the past three years, we have felt more than ever that our role has been to make sure the investment trusts we manage are in a strong position which allows them to respond to a changing economic landscape. During this time investors have increasingly taken a more long term view and this has led to a need for fundamental restructuring, particularly in high yielding trusts. This shift in attitude has allowed us to capitalise on our mainstream equity process to return sustainable high yield profits.
The history of our management of Shires Income PLC shows how it is possible, through adaptation, to develop strategies that will generate both growth in capital and a high level of income. This has been our goal since we acquired the trust from Glasgow Investment Managers in 2007. Aberdeen’s Pan European Equity team took over managing the trust in March 2008. While we have continued to deliver a high yield for shareholders, we felt it was important to simplify the composition and the mechanics of the fund to ensure greater transparency and aid understanding of how we generated returns.
We have brought this together with a sound investment strategy which encourages greater diversification to reduce risk while not sacrificing potential returns.
We believe it is important that a private client should be able to look at the fund and understand how both the revenue and capital gains are generated. These ideas of simplification and transparency have been the main drivers of change. The board decided that one of the first requirements was to rethink the way we handled gearing. Both the quantum and the structure of the debt needed to be more appropriate to the aims of the trust. In an attempt to achieve this, we decreased the gearing (leverage) from over 50% to 26%. At the same time we have replaced a complex inflation linked debenture with a more conventional and flexible bank facility.
We also considered that we needed to review our dividend policy. The board reduced it to a more sustainable level at the time of the 2009 final results. While the trust had previously paid a dividend of over 19.75p, the level was cut to 12p, which still represents a very attractive 6% yield today. Whilst any dividend cut is unwelcome, the credit crunch of 2008 and the associated recession made it vital that we re-base the dividend to a level that, in the absence of unforeseen circumstances, we regarded as sustainable. Further, this is supported by an appropriate level of revenue reserves and capable of delivering growth over the medium term. Although the current dividend is not wholly covered by our earnings, we currently have over a year’s worth of revenue reserves on the balance sheet. These are available to support dividend distributions from the Company especially during times of market volatility. To provide some context, if one considers the current level of shortfall in our earnings compared to our distributions, these revenue reserves would be sufficient to cover the difference for the next 15 years.
As we entered a time referred to by Ben Bernanke, the Chairman of the US Federal Reserve, as “unusually uncertain”, it was clear that simplifying gearing wasn’t enough. Transparency also ought to run right through the trust. We have reduced the reliance on alternative sources of funding, such as option writing, and improved the overall quality of the portfolio. Option writing used to generate up to 20% of the trust’s revenues, but we have cut that down to around 4%, which is a more appropriate level in our opinion. We also reviewed the contents of our portfolio, and exited some of the more esoteric holdings. A lack of liquidity meant that for some holdings this process took a number of years to complete. However, we now believe that the portfolio comprises good quality companies that will allow us to deliver our investment objectives over the medium term.
Aberdeen’s bottom-up investment process means that our portfolio construction is driven by fundamental analysis of a given company’s prospects. Many of the companies which the trust invests in are involved in long-term programmes which we believe will provide revenues way into the future. Rolls Royce and Weir are two examples of companies that have well-developed businesses servicing their after markets. Consequently, although they will not be immune from any slow down in their markets, their long term prospects are bright and they should be able to deliver structural growth through the economic cycle.
While we use the FTSE AllShare Index as a measure of comparison, we base our investment decisions on the company’s fundamentals rather than ‘benchmarks’. We believe that risk is absolute rather than relative to a benchmark. For this reason we are happy to be over or underweight any given sector, where this reflects our view of the attractiveness of the companies that comprise that sector. In terms of total return in the year ending March 2011 the benchmark increased by 8.7%, while the trust’s net asset value per share increased by 12.7%. We are well-known for a low portfolio turnover, and our methodology involves conducting sufficient due diligence such that when we invest in a company we have the intention and confidence to hold it for the long term.
We also believe in the importance of diversification and this is especially true when one considers how concentrated the UK market is in terms of the dividends it generates. Just 15 companies deliver over 60% of the total dividends distributed by the FTSE 100. Investors have seen all too clearly what can happen when a sector such as the Banks or a company, for instance BP finds itself in difficulty and has to cut or even pass their dividend. With this in mind we have a sizable holding in the Aberdeen Smaller Companies High Income Trust Plc. Small companies have been delivering good performance, and the company’s holding in this portfolio means that we can benefit from exposure to a wide range of small companies, that we know intimately. Small companies can deliver us a more diversified stream of dividends and, of equal importance, dividends that have greater potential for growth over the medium term. We also achieve diversification of the portfolio’s revenues through holdings of preference shares, which make up nearly 30% of the total portfolio. While these delivered a lower capital return than equities over the last 12 months, the higher yield that they generate makes them an important part of the income stream.
As demonstrated over the past three years, the fragility of the economic recovery has forced investors to reconsider what they expect of an investment trust. This has led to a need for investment trusts to be able to adapt. What this has taught us though, is that for a sophisticated investment vehicle, the principles of transparency and diversification are key, along with a consistent approach to investment. These testing times required a restructuring of attitudes, not only portfolios.
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