Monday, 17 March 2014

Investment Trusts

And Schroder Oriental Income Fund Ltd (SOI)

Caricature of Sir Philip Rose, Vanity Fair 1881, courtesy Wikipedia.

Sir Philip Rose founded the first investment trust in 1868 for investors of modest means. He called it The Foreign & Colonial Government Trust and it specialised in investing in Government bonds. In 1891 it changed its name to The Foreign & Colonial Investment Trust and it first started investing in equities in 1925. Today it has assets of £2.6 billion.  

Investment Trusts (ITs), whose shares are traded on the stock market like companies, have long been recognised as appropriate vehicles for illiquid investments in assets such as property, unlisted companies and infrastructure. Open Ended Investment Companies (OEICs, including Unit Trusts) and Exchange Traded Funds (ETFs), where investors may withdraw funds from the underlying assets, are not as suitable for such asset classes.

While ETFs have captured the largest share of managed equity funds, ITs hold certain advantages for equities over both ETFs and OEICs for the discerning investor. A major reason is that ITs generally perform better than either ETFs or OEICs in equity markets, according to an Investors Chronicle article (27 July 2012). This is confirmed by performance data, updated monthly, at

The following table covers 10 years' performance to May 2012 by sector.

Investment trusts
Oeics/Unit trusts
Global equity income
UK equity income
North America
Europe ex UK
Global emerging markets
Asia Pacific ex Japan

Source: Investors Chronicle 27 July 2012.

 ITs perform better than OEICs and ETFs for equity investors because:

·         The fees and expenses incurred by ITs are substantially lower than those charged by OEICs, though they are somewhat higher than ETFs.

·         IT managers can leverage their gains with borrowed funds.

·         IT managers follow long-term investment strategies, knowing that funds cannot be withdrawn from their portfolios. Managers of OEICs feel constrained by quarterly reporting and the fear that funds will be withdrawn if they perform below their benchmarks. As a result, OEICs sometimes become high cost index trackers.

·         ITs are never forced to buy or sell in their chosen markets. OEICs and ETFs are forced to do so as investors buy or sell their units. The ebb and flow of funds also increases the trading costs of OIECs and EFTs.

·         The price of OEICs and EFTs is linked exactly to the underlying fund's net asset value. Meanwhile ITs trade at a discount or premium to net asset value. This enables ITs to buy back their shares when they trade at a discount and to sell them when they trade at a premium to net asset value (NAV).

·         On average, IT managers add 'alpha' - they do better than their benchmarks.

Investment Trust investors will note that:

1.       The first step is to chose a theme - growth or income, geographical region, asset class etc. - and then review the available ITs listed at Morningstar or similar websites.

2.       The opportunity of buying assets at a discount to NAV should not be ignored. But there is usually a good reason for a high discount. INVISTA EUROPEAN REAL ESTATE IT trades at an 87% discount to NAV, but its borrowings are almost 6 times the value of assets and it is capitalised at only £7 million pounds. This is only for speculative investors. Evidently buying into an IT at a premium to NAV is best avoided, unless the investor has a compelling reason to do so.

3.       Unlike OEICs, ITs provide considerable information on their finances and investment strategies. This helps investors to find a manager who shares their investment criteria.

4.       As in any investment, it is a positive sign when managers own a substantial stake in their companies.

5.       While most ITs do not gear their investments by more than 10 to 15%, some do. This adds an element of risk, which in a downturn could hit the value of its shares.

6.       Small ITs, say with a free float of less than £50 million, are best avoided. Their shares can become illiquid and their bid to offer spread widen in a selloff.



Schroder Oriental Income Fund Ltd (SOI)

Sydney International Airport, courtesy Wikipedia

After a year when equities in the Asia Pacific region (excluding Japan) have recorded a net loss, compared to the substantial gains in the developed markets of the USA, Japan and Europe, it does not take much of a contrarian to take an interest in this region of the globe. When regions or asset classes are out of favour, the share price of investment trusts specialising in these areas often move to a discount. This is the case with Schroder Oriental Income Fund Ltd (SOI), which currently trades at a 5% discount to net asset value (NAV).

SOI Share price premium/discount to Net Asset Value, courtesy Investors Chronicle, click to enlarge

SOI was founded in July 2005 to "provide a total return for investors primarily through investments in equities and equity-related investments, of companies which are based in, or which derive a significant proportion of their revenues from, the Asia Pacific region and which offer attractive yields." (Company factsheet).

SOI has consistently beaten its benchmark, the MSCI Asia Pacific ex Japan Index:

Annualised Returns %
3 YEAR p.a.
5 YEAR p.a.
Since 2005 p.a.
SOI - Net Asset Value
MSCI Asia Pacific ex-Japan  GBP
Matthew Dobbs has managed SOI since its launch in 2005. According to FE Trustnet, he has outperformed his  peer group of managers by 77% in the past 10 years.  SOI has 68% of its funds invested in Australia, Singapore, Hong-Kong and Taiwan, with the remainder invested in China, South Korea, Thailand, New Zealand, Indonesia and the Philippines. Larger investments include Fortune Real Estate (Hong Kong), Taiwan Semiconductor, Sydney Airport, China Petroleum and Chemical and HSBC. The total number of holding is 72, which is not large for an IT with £400 million invested.

At its current price of 164p, SOI yields 4.5% and it is on a price earnings ratio (based solely  on revenue) of 19. The IT has a net gearing of just 3.3%. Seven institutional investors each own more than 3% of the fund's shares.

SOI has a good trading record. Consider:

1.       Revenue earnings per share (excluding capital gains and losses) and dividends have grown by 7% cumulatively per annum since 2007.

2.       SOI has returned a total gain on NAV of 148% since launch, 30% better than the benchmark return of 118% over the same period.

3.       Total charges amount to 0.93% per annum, about half the charges of a comparable OEIC.

4.       The fund issues or buys back shares to ensure that its share price does not move far from its NAV. By selling when the share price moves to a premium and by buying when it falls to a discount, shareholder returns are improved.

5.       The lead manager, from Schroder Investment Management, has been with the IT since its launch. Continuity, with a good performing IT, is important.

Using the dividend discount model, SOI would be valued at between 160p (discounting at 12%) and 260p (discounting at 10%), which compares to its current share price of 164p. This assumes that dividends continue to increase by 7% per annum indefinitely, though values beyond 20 years become tiny.

Main risks are:
Ø  The fund is highly dependent on what happens in China. Chinese gross public debt to GDP is estimated at 200% and for the first time public bodies have been allowed to default on their debts. Political risks in the region, both in North Korea and with Chinese claims in the East and South China Seas, are a concern.

Ø  The fund invests in a wide range of currencies, none of which are tied to sterling.

Ø  There is fear among investors that we may be on the brink of a financial crisis in the region.



Note: the next article will appear around 5 April.

Sunday, 9 March 2014

The Star Stockpicker

Benjamin Graham, courtesy Stokopedia

And Pearson PLC

Very few investors are consistently good stockpickers. Star stockpickers have the drive, dedication, technical skills and a gift that seems magical for finding stocks that are undervalued by the market. Normally these gifted people are found exclusively in fund management companies and the like. Only very few are known outside their industry. Even Benjamin Graham, whose Security Analysis (1934) was the first book to make investing a discipline, is barely known outside financial circles.

It is very rare to come across a star stockpicker who is a full-time financial journalist. For 15 years Simon Thompson has written a weekly column and more frequent online articles for the Investors Chronicle. For example, between 30 September 2012 and 30 September 2013 Mr Thompson tipped 60 shares listed on the London Stock Exchange. Taking the results of his tips to 2 October 2013, the average return on his buy recommendations yielded a profit of 22.5% compared to 4.5% for the FTSE All Share Index, which I use as a benchmark. On an annualised basis, the return on Mr Thompson's tips would have been about 45%.* Only 16 of the 60 shares he recommended subsequently performed worse than this benchmark. This success rate of 3:1 is remarkable.

How does Mr Thompson do it? He concentrates on a segment of the market, small cap shares often listed on the Alternative Investment Market (AIM), which is ignored by most analysts. He has a watch list of over 200 companies. Mr Thompson follows Graham's balance sheet analysis to uncover undervalued assets and to identify companies whose assets are well in excess of the company's market value. He uses a diverse range of indicators, such as director purchases, forward earnings expectations, the previous record of managers and major shareholders, positive news flow on the company and its market and technical indicators. He has published his investing ideas in two books.

Even if one emulated Mr Thompson's techniques, the time and energy he dedicates to stockpicking is beyond the capacity of most individual investors. And the individual investor is extremely unlikely to share his magical gift for ferreting out undervalued shares. The simplest way to benefit from Mr Thompson's gift would be to buy the online version of the magazine where he is published and to follow his advice. Mr Thompson's column cites the buying price on the eve of the online publication date and his target price for that stock.

However, this is not as straightforward as it seems at first sight. Consider:

Ø  Given that a certain proportion of his tips will not perform well, one in four of those in the year cited above, it is wise to buy them all. But who has the funds to buy sixty stocks in a single year? Investors must make a choice based on timing and the availability of funds.

Ø  Market makers read Mr Thompson's column and increase the offer price of the shares he tips at the start of the trading day. Then many other readers of his column buy the stock in the first hours of trading. The result is that, in five of his tips that I have taken at random, they have racked up an average gain of 11.2% in the first day of trading following his column. The gain sometimes occurs within two hours of the opening bell. If the offer price rises by 10 or 20% in the first hours of trading, then it is wise to wait for the price to drop or to skip that stock entirely.

Ø  Mr Thompson gives up to seven updates on a stock in a year and he also operates a stop-loss for when shares have dropped below a certain level. Investors reap the best results from his column when they tune in daily. Many people will find this impossible. The use of stop-losses, ratcheted up if the share price rises, is one way of dealing with this issue.

Once a year, in the month of February, Mr Thompson publishes his 'Bargain Portfolio' for the year. Eight to twelve stocks are selected using Benjamin Graham's asset-based model. Mr Thompson writes, "He believed that a bargain share is one where net current assets less all prior obligations exceeds the market value of the company by at least 50 per cent. Mr Graham's theory was that a strong balance sheet will usually see a company through any short-term difficulties; he called it his "margin for safety". As the number of companies that can meet this strict criterion have declined, Mr Thompson has relaxed this criterion.

One might think that the simpler way to gain from Mr Thompson's research is to buy into his Bargain Portfolio once every year in February, sell it a year later and then reinvest the proceeds. However, the Bargain Portfolio does not produce the same stellar results as his individual share recommendations.

Bargain portfolio
1 year performance %
1 year performance %
Compound return %
1999 to 2013
Compound return %
2004 to 2013

Source: The Investors Chronicle

While the compound return of this portfolio over the past 15 years excels, the return over the last ten years has only outperformed the benchmark by 1.4% per annum compounded. I write 'only' because, as with Mr Thompson's other tips, the stocks in the bargain portfolio suffer gains on publication and this will reduce future returns. Mr Thompson writes:

"It’s fair to say that my 2014 Bargain share portfolio has generated a huge amount of interest. Not only has website traffic from online subscribers been off the Richter scale, but the weight of money buying into the share recommendations has led to some significant price movements and that’s after factoring in the mark-up in the offer prices by market makers before the market opened on Friday, 7 February."

Given the instantaneous market reaction to Mr Thompson's tips, it would have been difficult for a regular investor to improve on a low-cost tracker of the FTSE All Share Index by investing only in the Bargain Portfolio in the last ten years (2004-2013). 

The reasons why stocks in the Bargain Portfolio do not perform as well as Mr Thompson's regular tips may be because:

1.  His selection criteria for his regular tips include many more factors than for the Bargain Portfolio. Consequently, it is much easier for other analysts to run the same stock screen he uses for the Bargain Portfolio, thereby limiting the expected gains.

2. He must create a portfolio of stocks for the Bargain Portfolio for a fixed publication date. Inevitably some will seem better than others when publication day comes around.

3. He does not set target prices for stocks in the Bargain Portfolio which are intended to be held for at least a year. Sometimes, he argues, you need to hold on to a share for years before its true value is realised. On the other hand, his regular tips are often special situations, where an outcome with an expected value is anticipated in a shorter period of time. In theory special situations should be riskier than the longer calls, but in practice this is not the case.

Mr Thompson offers good advice. Don't chase prices that rise sharply on publication day, as the froth will probably settle and the share price will fall back. He notes that stocks he has just identified as being undervalued rise further than subsequent upgrades of the same stock. And when the stock market crashes, as in 2008, hold onto the paper; stocks with good asset backing will recover.

The seasoned investor will note:

·         Mr Thompson's recommendations work best in a bull market. They will lose value in a bear market. Investors must consider what proportion of their assets they wish to place in his hands.

·         The short time horizon for buying and selling special situations may excite some investors but it will jar with other investors. There is no time to do your own analysis. These stocks are bought for quick capital gain and not long-term income. 

* The figures for Mr Thompson's share price performance are taken from the 2 October 2013 edition of the Investors Chronicle. He measures performance based on buying at the offer price and selling at the bid price. I have used only the first time he has tipped a stock, thereby excluding subsequent recommendations for the same stock.


Pearson PLC

An eBook reader, the Kindle


The Investors Chronicle, where Mr. Thompson writes, is owned by Pearson PLC.

Pearson is the largest education company in the world. It also owns the Financial Times, 50% of The Economist, and 47% of Penguin Random House, which is the largest book publisher in the world.

74% of the company's operating profit in 2013 came from its educational division. Pearson provides learning materials, technologies, assessments and services to teachers and students of all ages. The company concentrated on schools, higher education, English Language learning and business education.

74% of operating profits in 2012 came from its operations in North America. Pearson depends more on the American market than most large American companies do. Fifteen percent of its revenues come from emerging markets - primarily China, India, Brazil, Mexico, South Africa and the Middle East - which are, overall, growing strongly.

Pearson's traditional educational and publication businesses face competition from the internet and eBooks. The company has a strategy to deal with this unpleasant reality:

1. It aims to extend its business to emerging markets. They currently account for 15% of its sales.

2. It has moved from print to digital learning, which now counts for one-third of its sales.

3. It plans to move away from textbook publishing.

In 2012, Pearson acquired three companies in the online and digital fields. Pearson paid $650 million for the largest, EmbanetCompass, at the exalted valuation of 5 times sales. In 2014 it paid £435 million for the Brazilian Grupo Multi, the largest English Language trainer in the country, at 11 times operating profits. This acquisition is said to be slightly earnings enhancing.

After several years of good trading, Pearson has suffered from adverse trading conditions in its core markets (the US, the UK and Australia) to add to the challenge of eBooks replacing printed books. This has been the result of fewer students, new curriculums and a cutback in state funding. The new CEO warned that 2013 would be worse than 2012 and so it has proved:

1. Earnings per share, once adjusted for discontinued operations and a swathe of costs (mainly currency translation losses and acquisition expenses), has declined by 15% in 2013 and the Company projects a further fall of around 8% in 2014. Thereafter, management expects earnings to improve.

2. Return on equity (ROE) once averaged 15%, but has fallen to an (adjusted)  10% in 2013.  

3. Net debt to equity, a modest 16% in 2012, has jumped to 26% in 2013. Moody's gives Pearson a Baa1 credit rating for long-term debt, but in January 2014 it announced that it was putting the company's credit rating on negative outlook. 

4. Free cash flow declined to £238 million in 2013, after capital expenditure, well below the £372 million paid in dividends. As a show of confidence in the future, the Company has announced an increase of 7% in its dividend for 2014 though this is unlikely to be covered by free cash flow. This will most likely require further borrowings.

Pearson's share price (in blue), which usually follows the Dow Jones Index (in green) these last five years, has fallen by almost 50% compared to this benchmark in the past year:

Courtesy Yahoo, click to enlarge

At the current share price of 1003p, Pearson is on a forward (adjusted) PE of 15 and yields a prospective 4.8%.

My valuation model for the years 2014-18 gives a value of just over 900p for Pearson. The basic assumption is that the company hits the low range of its earnings projection of 62p a share for 2014 and then increases earnings by 3% per annum thereafter to 2018. If management achieve what they set out to do, this is a conservative valuation.

But what are Pearson's prospects?

John Fallon, Pearson's CEO is optimistic (from the 2013 results presentation):

  "We are in the middle of what we believe will be a short, but difficult, transition – one that through our combined investment and restructuring programs will drive a leaner, more cash generative, faster growing business from 2015.

   We are uniquely positioned to tackle some of the biggest challenges in global education including the transforming power of technology. I am particularly excited about the significant opportunity digital education offers for Pearson and the next generation of learners.”

There is evidence to support his optimism:

Ø  The global education market has grown by 75% in the 7 years since 2005 and it is forecast, by Ibis Capital, to grow by a further 43% in the next 5 years. World E-learning expenditure is expected to grow by 23% p.a. through to 2017. This bodes well for Pearson's E-learning business. However the rate of decline of its traditional print business will offset these gains, but by how much is difficult to judge from the information we have on the company's operations.

Ø  Pearson, with $7 billion in education related revenues in 2012, is the largest company in this market in the world. Its next largest competitor, Apollo Group, had $4.5 billion in revenues. Pearson claims, with some justification, to have an excellent offer in education. For example, it has joint projects with over 200 colleges in the USA.

Ø  The rest of the business - professional educational business (training, testing and certification of professionals), the Financial Times Group and Penguin Random House - is improving at a stately pace.

Investors will note that Pearson faces more uncertainties than many other businesses:

1. The 16-year reign of Pearson's outstanding CEO, Marjorie Scardino came to an end in 2012. Her successor has promised to speed up the changes in the organization, but to the outsider this is mainly visible for its corporate activity, the buying and selling of businesses.

2. The traditional print-based business is declining and while Pearson has moved to digital and online, these are markets where the company encounters new competitors.

3. In school and higher education Pearson is often in competition with the state, or at least it is dependent on government funding. 

4. If the recent acquisition of EmbanetCompass is a sign of things to come, Pearson will be paying a high price to gain expertise in its 'new' markets. It is in this context that it is worrying that management excludes goodwill amortization - effectively the cost of acquisitions - from their performance.

5. Three directors have sold shares worth £730k at 1143p to 1230p between April and May 2013. There have been no significant director purchases.

Note: I will be travelling for a further 3 weeks, and so I will be publishing only one more article before 5 April.