An update from our investment manager, Charles Luke
In this 15 minute podcast we are joined by Charles Luke, Investment Manager of the Murray Income Trust. Here he discusses the current environment, how the Trust was positioned going into the crisis, his thoughts on dividends and how he is looking to manage risk in the portfolio.
Recorded on Tuesday 12th May 2020
Past performance is not a guide to future results.
A Including current year revenue.
Interviewer: Welcome to the latest in our Aberdeen Standard Investment Trust Podcast series where we catch up with our investment trust managers to look at how the fallout from the Covid-19 outbreak is impacting their portfolios. Today we welcome Charles Luke, Manager of the Murray Income Trust. Hi Charles, can we start with a short history of the trust through this period? How were you positioned going into the crisis for example?
Charles: All things considered, we have been pretty well positioned with what has transpired, albeit we are not immune from all the consequences. The overarching aim is to manage the portfolio conservatively and that manifests itself in a couple of key attributes or characteristics of the funds. The first, the focus on dependable high-quality companies with robust business models and strong balance sheets, which have served us well as these are the sorts of companies able to maintain their dividends and do at least relatively well through this challenging period.
We are generally able to find more high quality companies in the consumer goods and pharmaceutical sectors and therefore we have healthy weights in those areas of the market, which should be more resilient and provide some downside protection and less of the portfolio is exposed to oil and gas and banks and insurance companies which have been weaker. Also, more generally, our focus on strong balance sheets has also been helpful. I think the second key attribute is that the portfolio is diversified as we do not want to be overly dependent on any one economic scenario or any particular sector or company and we are really conscious not to parrot the markets. So, for example, Shell was 1.5% of the portfolio when it announced its dividend cut, so not significantly impacted by that company.
We also have around 12% of the portfolio in some overseas listed companies and we write some options which has also really helped us to diversify our income. I think just finally, we only had very modest level of gearing going into the crisis, so that has worked in our favor as well.
Interviewer: Did you make any changes to the portfolio as the crisis unfurled?
Charles: Well, over the last 20 years or so I found that in situations like this there is a very strong temptation to trade the portfolio and overreact to lots and lots of noise that is going on. I try my best not to do that because I think it is really important to keep focused on the long term. There is also the siren call of investing in lower quality companies with better near-term yields to generate a bit more income but that seldom works either. We have made some changes to portfolios, selling a couple of smaller holdings in companies that are likely to struggle or at least find life a bit more difficult in a post Coronavirus world, so for example, Compass, where we are likely to see more working from home. They are likely to have greater costs. Also, Signature Aviation and a residual holding in HSBC and with those proceeds we bought a holding in SANNE which is an alternative fund administrator, Fever Tree on the basis that the market has factored in a very good chance of success in the United States and also Coca Cola Hellenic, so really trying to maintain the good quality and growth profile of the portfolio.
Interviewer: When you are making these assessments, how are you making a distinction between companies that are just experiencing sort of a short-term flip in earnings and will recover and those where the outlook has fundamentally changed or is that the million-dollar question?
Charles: That is a really interesting point you make. Trying to identify whether when a company finds life more difficult which is due to temporary factors or permanent phenomenon is something we grapple with all the time and not just at the moment. I am part of a large team and fortunate to work with 15 very talented investment analysts and a large team allows us cover all of the FTSE 350 with our research coverage. A large part of our proprietary research revolves around understanding the dynamics so what is changing the business so focusing on exactly the question you asked. The sector knowledge in the team is very strong. We talk to a lot of independent experts, we have first class access to management teams, as well so we can test any hypothesis with them. Obviously, we do not always arrive at the right answer, but for example, identifying an improvement in quality before the market can can lead to some very healthy gains and in the trust we have holdings in Rentokil and ConvaTec that have performed very strongly on that basis.
Interviewer: What about the market in general? Do you think the market has bounced quite a long way, do you think that market prices now reflect the risks out there or does it very much depend on which sector you're looking at?
Charles: I would say in general investors in companies themselves are not necessarily good at understanding risks, which is why focusing on good quality companies is important. Therefore, a company with the right business model in the right industry with the right management and a strong balance sheet is going to help offset the challenges that come to all businesses over time. However, as we stand today, I think only time will tell if the risks are reflected in prices, but I am not particularly optimistic about a V-shaped recovery. I think we are in a low growth, low inflation, high debt, high unemployment and weak demand world for quite a long time to come.
The other thing I would say is that in some sectors, particularly in the likes of travel and leisure, valuations do seem to look cheap, but the outlook is so dependent on knowing such as treatments for Coronavirus or timing of vaccines or the impact of social distancing and behavioral changes that having any competence and that view is difficult. Finally I think we have seen companies come to the market to raise capital of up to say 20% of their shares through placing, but we have not seen the rights issues yet for greater amounts of money for those companies with a weak balance sheets and that is because it takes time for a prospectus to be written and due diligence to be completed. Over the next month or so I expect we will see more companies coming to market for larger amounts and that will probably make valuations look less attractive as you find a company on a high single digit p/e is actually probably more on a mid-teen p/e as the number of shares on issue increases, so I think that's also something to bear in mind.
Interviewer: Presumably you are talking to the companies in your portfolio all the time and are they reflecting that uncertainty, what kind of feedback are you getting from them?
Charles: We are having quite a lot of similar discussions. It tends not to vary too much by sector and topics are generally the safety of staff and the ability to work from home or with social distancing, then there are some discussions around the company’s balance sheet and liquidity, the extent to which it needs to be able to take advantage of government help. Most of the companies in the market have withdrawn guidance and so the outlook is very opaque and they know as much as anyone else. In terms I think of trying to define the future, people try and find historical comparisons so look what happened in the GFC and then those sort of international companies with operations in China or South Korea or Australia are wondering how much they can extrapolate from what they’re still seeing in those countries at the moment.
I think nearly all the companies we talk to are still very cautious and unfortunately many are looking at cutting costs and redundancies when the furlough scheme ends and you typically find that management teams are quite reluctant to call the bottom as they tend to not look very clever if they get it wrong and so typically err on the side of caution. But I do think many of them are actually very worried about the future at the moment.
Interviewer: Clearly income is important for this trust, and dividends have been an area of a pressure point. What do you see as the landscape for dividends now and how are you handling that in the portfolio?
Charles: As I said before, the key thing really is not to compromise the long-term total return potential of the portfolio by investing in poor quality companies with ultimately unsustainable dividend yields. What we are seeing is completely unprecedented and I think we are up to 42 companies in the FTSE 100 that have cut or suspended their dividends and that includes Shell, which has always been the touchstone or totem for dividend security. So, having a focus on quality and strong balance sheets has been very helpful for the portfolio, as has been being able to invest overseas. Of our nine overseas holdings, eight of those are Roche, Novo Nordisk, VAT, Telenor, Microsoft, Total, Nestle and Kone have all maintained or increased their dividends. We also have a small holding in Mowi, which is a Norwegian sustainable kind of pharma which has unfortunately suspended dividends but we would expect it to restart that dividend later in the year. Helpfully we have the ability to write some options which has been very valuable at times like this, providing a really useful independent uncorrelated income stream.
Options normally account for around about 5% of the portfolio income, but having been concerned by valuations at the start of this year I have written more calls than usual which will help the revenue account. In the UK holdings, we have been underexposed to the large dividend payers as part of our diversification strategy so we had a lower exposure to the oil majors. We do not own the likes of Lloyd's or RBS or Barclays and has limited exposure to insurance companies and also the travel and leisure sector so that has been helpful. That is not to say we have not been impacted because as we currently stand around about a quarter of the holdings by value have cut or suspended their dividends, but many of those companies are actually relatively low dividend yielders like Rentokil, AB Foods, and Marshalls.
The assumption is that on a calendar year basis the impact on the income generated is likely to be around about 20% but then with the additional income from options, that translates into perhaps a 15% to 20% decline in income. I think that compares to the market which is likely to be around about 50% or so reduction in income and we are certainly relatively well positioned from that perspective. I would say also that next year we would expect many of the companies that have suspended their dividends in the portfolio to return to the dividend because they all are inherently strong companies with good balance sheets. But I think I am a lot less positive on the market in general returning to the past levels of income as the focus for many companies over the next few years will be simply on paying down debt.
Of course, one of the benefits of an investment trust is the ability to maintain a rainy-day revenue reserve and Murray Income has some very strong revenue reserves and of course we have our 46-year track record of giving growth which I know the board is very keen to maintain.
Interviewer: What about the growth side, obviously it looks like economic growth will be very slow. Will it be a case of finding those pockets of growth in the economy areas like pharmaceuticals and things like that as we look forward?
Charles: I am guessing it is certainly going to be the case that we are going to see a period of lower growth driven by weak demand, high unemployment, companies with stretched balance sheets being less able to invest. We will probably see tax increases so growth is definitely going to be harder to come by and I think those companies that can deliver growth are likely to be prized more highly and that is why we try to focus in on them in the portfolio. I also think that companies with strong balance sheets will have significant opportunities, for M&A and in the world where many dividends are being cut those companies that can generate a healthy and secure yield will do very well.
Interviewer: Have you changed anything about the way you manage risk in the portfolio? Perhaps paying closer attention to cash flow for example, or have you really always done the things that would sort of highlight problems in this environment?
Charles: There is no real change to the way we think about risk. For us it is about understanding the companies we invest in, trying to find quality companies with sustainable competitive advantages and experienced management teams and then putting together a diversified portfolio with the benefits of overseas companies which provide access to industries that we cannot find in the UK and trying not to be overly dependent on any one economic scenario. I think to my mind investing in attractively valued companies with strong balance sheets, paying healthy dividend yields is a good way to reduce risk and it will certainly help the portfolio to outperform its benchmark over a long period of time.
Interviewer: And just finally, what reassurance would you give investors in this tricky and volatile climate?
Charles: That question really pulls together all the different threads that we have talked about, so firstly we went into crisis in a relatively strong position and modest gearing, secondly the focus on high quality companies has been helpful from a capital resilience perspective, but also I think in terms of relative income resilience. Of course, the income picture is helped by our revenue reserves and we have tried to focus on the long term and not buying companies with the expediency of short-term income or lowering our quality threshold. We are in a world of low interest rates, low inflation, and weak growth and companies with strong balance sheets, healthy dividend yields and strong growth prospects should perform well and that's how the trust is positioned.
Interviewer: Great, thank you so much Charles for those insights today and thank you too all our listeners for tuning in. You can find out more about the trust at www.murray-income.co.uk and please do look out for future episodes, many thanks.
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