City of London lags benchmark but adds value with stock selection – QuotedData
City of London (CTY) has announced its annual results for the year ended 30 June 2020, during which it lagged its benchmark, but stock selection was positive. During the year, CTY’s total return was -14.6%, which the trust says was behind its benchmark, the FTSE All-Share Index, which returned -13.0%. CTY’s share price return was -16.2%, reflecting a small widening of the discount during the period. CTY’s Board decided to raise the dividend by 2.2%, thereby providing the 54th consecutive annual increase, although this was partly funded from revenue reserves. The chairman, Philip Remnant CBE, highlights that almost half of FTSE 100 companies, in which CTY is principally invested, have passed or cut their dividends in 2020. During the year, stock selection was positive, adding 0.90% to returns, while gearing was negative, detracting 2.40% from returns
Comments from the investment manager, Job Curtis, on the investment background
There was a marked contrast between the performance of the UK equity market during the first half of the period under review compared with the second half. Over the six months to 31 December 2019, UK equities produced a total return of 5.5%, as measured by the FTSE All-Share Index. In December, the decisive Conservative general election victory boosted domestic sectors given the end of the political paralysis. Utilities, which had been threatened with nationalisation by Labour, did particularly well.
During the six months to 30 June 2020, the direction of the equity market was driven by the spread of Covid-19 across the globe, the government enforced lockdown of the economy and then the easing of those restrictions. From 31 December 2019 to the low point on 23 March 2020, the FTSE All-Share fell by 35%. There followed a significant rally which reduced the losses, so the FTSE All-Share Index produced a negative return of 13.0% for the 12 months to 30 June 2020.
Globally and in the UK, governments and central banks responded to the lockdown of economies with an unprecedented level of policy stimulus. In the UK, the government paid 80% of wages of those furloughed and introduced loan schemes for businesses. The Bank of England cut its base rate from 0.75% to 0.10% in two stages. The 10-year Gilt yield, which was 0.84% at 30 June 2019, ended the 12-month period at 0.12%, reflecting the low base rate, investors’ perception of weak growth and inflation prospects and also the large purchases of gilts that were made by the Bank of England. The dividend yield of the equity market remained significantly higher than the base rate and the 10-year Gilt yield. Given the huge uncertainty during March and April, a large number of dividends were cut, cancelled or omitted as companies prioritised the preservation of cash.
The oil price suffered from the global decline in economic activity. There was a big drop in demand for oil with there being much less travelling whether by car, aeroplane or cruise ship as people stayed in their homes. In addition, oil producing countries were slow to respond by reducing supply because of a dispute between Saudi Arabia and Russia.
Sterling started the 12 months at a 1.24 exchange rate to the US dollar and rallied to 1.32 after the general election in December. Sterling fell to 1.15 at the height of the crisis in March when the US dollar was attracting investors as a safe haven. It recovered to end the 12 months at 1.24, which was the same as where it started. Sterling’s performance against the euro was similar to its performance against the US dollar.
Over the 12 months to 30 June 2020, the FTSE 350 Higher Yield Index (the higher dividend yielding half of the largest 350 shares listed in the UK) underperformed the FTSE 350 Lower Yield Index (the lower yielding half othe largest 350 shares listed in the UK), reflecting poor returns from the banks (-40%) and oil and gas (-44%) sectors.
Estimated performance attribution analysis (relative to FTSE All-Share Index total return)
Source: Janus Henderson
Stock selection was positive over the year, with the biggest sector contributor being under-represented in oil & gas, mainly through the underweight position in Royal Dutch Shell, which was the biggest stock contributor. The second biggest stock contributor was being underweight in HSBC, followed by owning Microsoft, not holding Rolls Royce and owning Nestlé and pub group Greene King, which was taken over by CK Asset Holdings of Hong Kong.
The biggest detracting sector was being under-represented in pharmaceuticals and the underweight holding in AstraZeneca, which was the biggest stock detractor. AstraZeneca has benefited from the success of new drugs brought to the market and has grown to be the largest stock by market capitalisation in the UK index. Not owning London Stock Exchange was the second biggest stock detractor, followed by owning Hiscox and Lloyds Banking, not owning Experian and owning Carnival.
The main reason that City of London’s net asset value total return underperformed the FTSE All-Share Index over the 12 months was the effect of gearing, which detracted by 2.4%. Gearing started the 12-month period at 7.9% and stayed below 10% until March, when it peaked at 11.1% before falling back to 9.7% at 30 June 2020. In rising markets, gearing enhances the rise in net asset value, but it has the opposite effect in a falling market, such as over the 12 months to 30 June 2020. In addition, City of London’s Private Placement Notes rose in value, which detracted from the net asset value with debt at fair value.
Over the long term, City of London has significantly outperformed the FTSE All-Share Index. For example, over 10 years, City of London’s net asset value total return is 120.1% compared with 91.8% for the FTSE All-Share Index.
Portfolio review from the investment manager, Job Curtis
Over the last three years, the number of holdings has been reduced from 115 at 30 June 2017 to 97 at 30 June 2019 and to 90 at 30 June 2020. In our view, while it is beneficial for a conservative portfolio to be diversified, at 90 holdings there is more focus with each holding having more impact.
The sector which had the largest number of holdings sold from it was travel & leisure. Pub group Greene King was sold after it accepted a takeover bid from CK Asset Holdings of Hong Kong at a level significantly in excess of its previously prevailing share price. Travel group TUI was sold in December 2019 amid concern about its rising debt and after it cut its dividend for a second time. This proved to be a very good sale given the effect of the restrictions on tourism on TUI in 2020. In our view, the social distancing rules brought in as a result of Covid-19 had a particularly severe effect on the leisure and hospitality sectors, which would be slow to recover. Therefore, complete sales were made of the holdings in Cineworld (cinema operator), Compass (contract caterer) and Whitbread (hotel operator). 60% of the holding in cruise operator Carnival was also sold. In addition, William Hill was sold given the continuing structural challenge of its betting shops.
One new holding was bought in travel & leisure: La Française des Jeux (“FDJ”), which has been the operator of the French national lottery since it was created in 1933 and has an exclusive license for the next 25 years. An initial holding was bought in FDJ when it was privatised by the French government in November 2019 and additional purchases were made in the aftermarket. FDJ is a cash-generative business with a strong balance sheet and its shares have performed well.
The banks sector was also badly affected by the lockdown of the economy and its aftermath. Although UK banks have much higher levels of capital than at the time of the financial crisis (2007-2009), they remain leveraged institutions and vulnerable to economic downturn. In addition, the regulator of the UK banks, The Prudential Regulatory Authority, banned them from paying dividends in 2020 in order to conserve their capital given the uncertainty. The holding in Royal Bank of Scotland, which had been bought in the second half of 2019, was sold. The other bank holdings (HSBC, Lloyds and Barclays) were reduced but smaller positions were retained given the recovery potential.
The portfolio has been under-represented in general retailers because of the structural threat to retailers on the High Street and in shopping centres and retail parks from the growth in internet shopping. The lockdown of the economy accelerated this trend, with all but essential shops having to be closed for a period. Given its challenges and the suspension of its dividend, the holding in Marks & Spencer was sold.
By contrast, food retailers were, of course, allowed to remain open. They benefited from the closing of restaurants and pubs with more food and drink consumed at home having been bought in supermarkets. It was therefore disappointing that Sainsbury omitted to pay a final dividend and the holding was sold. A new holding had been bought in Wm Morrison, which has a relatively strong balance sheet and a differentiated strategy, including producing around half the fresh food it sells. Subsequently, the holding in Sainsbury was replaced with Tesco, the UK’s largest food retailer. Tesco has been turned around in recent years with the disposal of most of its overseas operations, net debt reduced, prices in stores more competitive and fewer promotions.
The oil & gas sector was a relative loser from the lockdown, with significantly reduced demand as well as supply issues causing oil price weakness as discussed above. With the oil price at a level where its dividend was a long way from being covered by free cash flow, Royal Dutch Shell cut its dividend for the first time since 1943. BP also cut its dividend in August 2020. Both companies are intending to invest more in renewable energy. The portfolio has been underweight relative to the FTSE All-Share Index in both Royal Dutch Shell and BP. Reductions were made to the stake in Royal Dutch Shell after its dividend cut. A new holding was bought in Total, the French listed international oil company, which has a lower cost of production than Royal Dutch Shell and BP and a stronger balance sheet.
The iron ore price was relatively stable over the 12 months, supported by Chinese steel demand. Iron ore is the most important commodity for Rio Tinto and BHP. Additions were made to the stakes in both companies, which were highly cash-generative at the iron ore prices that prevailed and they both increased their ordinary dividends.
In life assurance, Prudential split into two businesses, Prudential and M&G. The larger, Prudential, operates in Asia Pacific and the US; M&G owns the UK business and is classified in the financial services sector. Additions were made to M&G given the scope for capital generation and dividends. The sale of the holding in Aviva was completed in January 2020 and it subsequently did not pay a final dividend. A new holding in Legal & General was bought on an attractive yield after it confirmed its dividend.
The UK telecommunications sector has been very competitive and with tough regulation for many years. The incumbent, BT, has been struggling and decided to stop paying a dividend. City of London’s holding in BT was sold and reinvested in Deutsche Telekom, Vodafone and Orange. For several years, the largest telecommunications holding in the portfolio has been Verizon Communications, the US operator, which has a steady record of dividend growth.
The utilities sector had a good year with the general election removing the threat of nationalisation. City of London benefited by being overweight in utilities relative to the FTSE All-Share Index, with the largest holding being National Grid. One new holding was bought, Pennon, which is the water utility covering the south west of England. Pennon sold its waste business for a good price leaving it with a strong balance sheet and good dividend growth prospects.
Sales were made in four other small holdings. Senior is an aerospace supplier adversely affected by weaker demand for its products. For Royal Mail, the decline in revenues from letters is not being offset by the growth in parcels and cost reductions are hard to achieve. Bank note printer De La Rue is faced with the trend to electronic payments as well as losing the UK passport contract. Connect Group’s diversification away from its core newspaper distribution operation was very costly and caused the suspension of its dividend.
The portion of the portfolio invested in overseas listed companies increased over the year from 10% to 14%. This was offset by reductions in the portions invested in large UK-listed companies from 78% to 75% and in medium-sized and small UK-listed companies from 12% to 11%.
Large companies (FTSE 100) underperformed medium-sized (FTSE 250) and small (FTSE Small Cap) companies over the 12-month period, with a key factor being the poor performance of banks and oil companies, which are mainly in the FTSE 100.
Portoflio outlook from the investment manager, Job Curtis
The portfolio is structured to have a solid base of companies which are defensive, being relatively less exposed to the cyclicality of the economy. In addition, there is some exposure to companies where share price valuations are depressed and there is significant recovery potential.
Consumer staples or makers and sellers of essential products comprise 21.5% of the portfolio and includes companies in the following sectors: beverages, food producers, household goods, personal goods, tobacco and food retailing. City of London’s largest three holdings, British American Tobacco, Unilever and Diageo, are consumer staples stocks. They are global leaders, have built brands over decades but need continually to invest in product innovation to grow.
The pharmaceutical sector is a second reliable area for profits so long as the companies spend on research and development to discover new drugs to replace those where patents are expiring. City of London has a significant part of the portfolio invested in pharmaceutical companies, at 8.5% of the total, although this is below the FTSE All-Share Index level. Utilities should also be a defensive source of income, subject to satisfactory regulatory regimes. 6.6% of City of London’s portfolio is invested in this area. 5.1% of the portfolio is invested in telecommunications operators, which should be stable provided regulation is fair or competition not too intense. Within financials, life insurance and financial services companies have been much more reliable dividend payers than banks. 6.5% of the portfolio is invested in life assurance and 5.3% in financial services.
It is encouraging that, since the start of City of London’s new financial year (on 1 July 2020), a number of companies have returned to paying dividends, such as BAE Systems, Persimmon, Direct Line Insurance, IMI and Mondi. There are other companies in the portfolio, which did not pay dividends in the first half of 2020, where positions have been retained (sometimes reduced from the previous size of holding) where there is significant recovery potential and scope to pay dividends, such as in the banks, home construction and real estate investment trust sectors.
Although it is disappointing that Royal Dutch Shell and BP cut their dividends, they remain dividend payers and should benefit from a recovery in global economic activity. In addition to some oil & gas exposure, 6.0% of the portfolio is invested in mining companies (Rio Tinto, BHP and Anglo American) which derive their profits from important commodities, such as iron ore and copper, which should be underpinned from increased infrastructure spending as governments act to support economic recovery.
It has been a very difficult period for company profits and dividends because of the Covid-19 virus and associated lockdowns of economies. There are clear signs that the worst point has been experienced and an improvement should be seen going forward. In our view, the portfolio is predominantly invested in defensive, relatively stable companies but also has some exposure to areas with significant recovery potential.