Japan is set to surprise investors, Alasdair McKinnon of the Scottish Investment Trust tells Merryn Somerset Webb. Below, Max King takes a closer look at the trust’s prospects.
MoneyWeek loves a contrarian, so it will be no surprise to readers that both Max King and I have separately had a chat with Alasdair McKinnon, one of the few real ones in the investment-trust sector, over the last few weeks. You can get a good sense of McKinnon’s portfolio from Max’s analysis below, but our conversation started (as so many do) with Japan.
Look back in 30 years, McKinnon says, and there’s a very good chance that Japan, a “populous, industrious and intelligent nation”, will turn out to “have been one of the best places to put your money”. Its recent history shows just “dramatically things can change – and how surprised most people are when they do”. A mere 30-odd years ago, Japan had the world’s largest equity market, we were all in awe of it, and “investors couldn’t get enough of its stocks”. Japan was the future. A few decades later, when the bubble burst, it was considered a global basketcase.
The collapse changed everything – including fertility. In part thanks to people not feeling well off enough to have kids, Japan now has a lower fertility rate than China. So what next? McKinnon reckons the tide is turning. Global investors may have written Japan off, but its politicians haven’t. Since 2012, Shinzo Abe’s government has taken drastic steps to turn Japan’s economic prospects around.
The key to this is developing inflation, something McKinnon reckons that Abe and the central bank can probably manage in the relatively near future. The difference between the West (which also claims to want inflation) and Japan is that in Japan everyone – the population, the fiscal authorities and the monetary authorities – all want inflation. While in the West workers have very little power (union membership is low), in Japan workers have a great deal of power should they choose to use it (they are both well represented and in short supply).
Property and banks will benefit from inflation
With that in mind, McKinnon is keen on property and the banks. These “all but went bust in the early 1990s”, but are now “super cheap” and more solvent than most. They also have more money than they know what to do with (which will be good when borrowing picks up) and will be beneficiaries of inflation when it comes. The trust holds Sumitomo Mitsui Financial Group and Bank of Kyoto.
I wonder if he sees any similar value in the West. He worries that we will take as long to move out of stagnation as Japan did – we shouldn’t discount the idea that it gives us a “depressing roadmap”. He also fears that we have a long-term structural problem with equity markets in the West. The pensions industry used to be a “perpetual buyer of equities”. But things have changed. An ageing population means that more is beginning to come out of pension funds than go in and regulatory change has pushed big funds into bonds rather than equities. There is also a new mentality in the way pension cash is invested.
The shift from defined-benefit (DB) pension funds (a guaranteed income in retirement from a scheme) to defined-contribution (DC) funds (you invest and you take the risk) suggests a shift to a lower-risk method of investing. Those of us with DCs know we can’t afford to lose 20% of our money – so will we keep investing in equities over the long term in the same way as big DB funds forced to be in it for the long term did in the old days? Maybe not. The shift from an era of effective socialisation of pensions to one of personal responsibility could be a huge dampener on equity markets over the long term.
The new tech bubble
McKinnon is also concerned about some of the popular tech stocks distorting the market. Back in the late 1990s value investors (me included) were stunned by the arrival on the scene of cash shells – listed companies with no assets but cash waiting to be invested, valued at premiums based on expectations of their young founders’ genius. He sees the same dynamic in many newish firms today. Think, he says, of the likes of Uber, Airbnb and Amazon. Sure: they’ve got revenues. But lots of them are “giving away a ten-pound note” every time they sell anything, too.
There’s also something oddly 1990s about all the “puff pieces” in the papers about the “25-year-old geniuses” running firms that have “minute revenues, are hugely loss-making and have business models based around grabbing market share at any price”. That market share might look like it is worth a fortune – but it certainly won’t be when regulators step in to curb monopolies.
I wonder what we might buy in the UK, which is supposed to be the cheapest of the developed markets. Surely it’s a contrarian paradise? Look sector by sector and you’ll find things, he says. The banks are “pretty bombed out” (for example: the trust has just bought RBS on the basis that it could soon become one of the “biggest yielders in the UK”). Listed real-estate investment trusts (Reits) are also interesting. The biggest holding in the portfolio is Tesco (at 4.3% of total assets).
The key thing to remember when wondering why is that it’s hard and expensive to distribute fresh products around a nation. That tells us that dominant players in grocery today will remain the dominant players. No need to worry about competition from internet-only companies: when it goes wrong for them, which it will, Tesco will “get its margin back”.
Successfully swimming against the tide
A generation ago, the investment-trust sector was dominated by sleepy, generalist trusts, mostly based in Scotland, writes Max King. These long-established trusts had, at best, a mediocre record, traded at large discounts to net asset value and were supervised by complacent, self-serving boards of male directors.
Persistent corporate action by vulture funds and disgruntled larger investors has forced reform on the survivors, many having shrunk considerably in size. Performance has improved, discounts have fallen, the investment focus has been sharpened and corporate governance strengthened. These trusts can again be considered core holdings in any portfolio or even sole investments for those without the resources or inclination to diversify.
The self-managed Scottish Investment Trust, founded in 1887, was one of the last to see the light, but the benefit of change is now apparent. Despite it swimming against the tide in terms of style, performance has matched that of the MSCI World index over three years and is ahead over one. The discount has fallen below 10% and the dividend, increased annually for 34 years and by over 8% per annum for the last ten, provides a respectable yield of 2.4%.
With assets having shrunk to £827m through buybacks, it is no longer one of the sector giants, but is large enough to be liquid, small enough to be nimble. As a self-managed trust, there are no other clients competing for the manager’s best ideas and the total costs are just below 0.5% per annum.
Favouring the out-of-favour
McKinnon has managed the trust since 2014 with a contrarian style. The persistent outperformance of growth stocks, especially tech, has thinned the ranks of the contrarians, but this is helpful; for those who invest against the trend to be successful, they must be few in number, or they will unwittingly represent the trend. He describes contrarianism as “thinking for yourself rather than with the crowd and being prepared to put your money behind it”. At present, “this lends itself to a value style”. However, “the crowd is sometimes right, so contrarians do better at some stages of the cycle than others”.
A high exposure to the UK relative to the US market and less than 5% in the technology sector has held back relative performance in recent years, but would give it a boost if the wind changes. Besides, two-thirds of the 31% invested in UK is in international earners and only one third in domestic stocks such as Tesco and M&S. Tesco can double margins from 2% to 4%, McKinnon believes (a target still well below the 6% it once achieved), while a focus on distribution rather than new megastores has improved competitiveness.
These investments are mirrored in the US holdings, 32% of the portfolio, by Gap and Macy’s, which face similar challenges to their UK counterparts. A chunky 27% of the portfolio is in resources, two-thirds in energy and one-third in mining. “People were very depressed about the sector in late 2015,” McKinnon says, “but miners recovered quickly as Chinese demand bounced back. People wrongly believed that oil demand would be threatened by alternative energy and that fracking would keep the market over-supplied. Meanwhile, energy companies cut capital expenditure and focused on cash flow.”
Financials, mainly banks, account for another 20% of assets, the largest holding being the Asia-focused Standard Chartered. “Bill Winters, the new chief executive, is very impressive and the quality of the loan book, much of which is linked to commodities and China, is improving.” As well as its recent investment in RBS, the trust also holds France’s BNP Paribas. “It was incredibly cheap with a good yield as nobody believed management would deliver a recovery.”
Rentokil is the second largest holding: “A darling growth stock that went horribly wrong so the shares became incredibly cheap.” The core pest control business, he believes, has a strong market position around the world and the potential to raise margins significantly while Rentokil is exiting other businesses.
An £82m debenture, costing 5.75% per annum and not repayable until 2030, means that borrowings are expensive, especially as there is £49m of un-invested cash. Still, having, as McKinnon modestly says, “done okay in the last three years”, the trust is perfectly placed for contrarian investing to return to favour.