Faith Glasgow discusses how the structural attributes of investment companies can help in an inflationary world.
It’s the highest rate of inflation since September 2011, when it hit 5.2%. And it’s clearly worrying investors. A recent survey of customers by broker interactive investor found that inflation was the second greatest concern behind a stock market crash, cited by 22% of respondents.
Prices have been pushed up by a combination of factors, including supply-side and labour shortages, spiralling energy costs and escalating demand. For investors, the danger is that the value of some assets will not keep pace (cash and fixed interest holdings being obvious examples).
Investment companies, however, can work very effectively in an inflationary environment. To a large extent this is a reflection of their closed-ended structure and the type of assets particularly favoured by this structure.
Because they issue a fixed number of shares on the stock exchange, investment company managers don’t have to buy or sell assets in response to changes in investor demand, as open-ended fund managers do. Instead, investor demand plays out through changes in the share price and the discount to net asset value.
As a consequence, as Rob Morgan, chief analyst at Charles Stanley, explains: “Investment trusts can be more appropriate vehicles to access more esoteric, ‘illiquid’ real assets that cannot be traded easily.” Many of these happen to be well suited to protecting against inflation, and we’ll look at them shortly.
There are other structural attributes that also help investment companies beat inflation. The closed-ended structure means managers don’t have to reserve a chunk of cash specifically to cover redemptions, so, as Morgan points out: “There can be less ‘drag’ from low-return cash.”
For income seekers seeking a steadily rising real income, trusts’ ability to hold revenue reserves of up to 15% of annual dividends received and use them to grow or maintain payouts in less prosperous years is also important.
Additionally, the facility to gear or borrow to invest with the aim of enhancing returns can help investment companies beat inflation, adds Morgan, “especially if debt is secured at an opportune time at a low rate”.
As we’ve seen already, investors favour closed-ended funds for investment in ‘real’, physical assets such as infrastructure, renewable energy and commercial property, because they are typically not easy or quick to trade.
These types of assets tend to pay returns at least partially linked to inflation. For instance, says Mick Gilligan, head of managed portfolio services at Killik: “Several infrastructure trusts disclose an ‘inflation delta’ – an estimate of the sensitivity of their NAV to the inflation rate.”
He gives the example of HICL Infrastructure, which estimates its inflation delta to be 0.8. “So if inflation turns out to be 1% a year higher than HICL’s base assumption, in every future forecast period the expected return from the portfolio would increase by 0.8%.”
Ben Yearsley, investment director at Shore Financial Planning, picks out renewable energy trusts. “Many of them benefit from Renewable Obligation Certificate (ROC) payments from energy suppliers, effectively meaning that some of the electricity they generate is sold for a predetermined price that increases with inflation every year.”
Greencoat UK Wind specifically links its dividends to ‘RPI inflation and real NAV preservation,’ says Andrew McHattie, publisher of the Investment Trust Newsletter. Similarly, he adds: “Bluefield Solar Income says that two-thirds of its revenues are directly linked to RPI, meaning that earnings would naturally rise in an inflationary environment.”
The downside, however, is that most trusts in the various infrastructure sectors trade on a premium, in several cases a double-digit one.
Another obvious sector for inflation protection is commercial property, continues McHattie. “Many leases provide for rental payments to increase in line with inflation, and there is a wide range of property trusts available, including generalists like Standard Life Property Income and specialists such as Tritax Big Box, Supermarket Income REIT or Impact Healthcare REIT, where all leases are inflation-linked,” he comments.
Morgan warns that some of the generalist property trusts, particularly retail-focused ones, have struggled in recent years in the face of online competition. “Areas with overcapacity are less likely to make a good inflation hedge, due to the structural challenges,” he argues. “However, other areas such as warehouses, logistics, data centres and healthcare property could be more resilient.” Again, though, valuations among these specialist trusts tend to be more expensive, with large premiums prevalent.
Equity strengths - and vulnerabilities
What about more conventional equity-focused investment companies? Over the longer term, the combination of capital growth and dividend payments tends to offset inflation, but there’s no guarantee of equities delivering either over the short term.
Equities can be potentially vulnerable in several respects. First, as Morgan explains: “High levels of inflation tend to be something of a double-edged sword. If a company cannot pass increased costs onto customers, then it can result in a fall in sales and profits.”
He therefore favours trusts investing in firms with ‘pricing power’, whose products and services are in strong demand and can put up their prices to reflect higher costs, such as the smaller-cap Smithson Investment Trust. In their hunt for pricing power and resilience, the managers target “sellers of small ticket items that are consumed regularly, dominant operators within a niche, franchisors and businesses with strong brands,” Morgan adds.
Another problem, for growth-focused companies in particular, is that inflation tends to spark interest rate rises, making corporate debts more expensive to service.
However, observes Gilligan, natural resources stocks are an exception to that generality, because of the strong link between commodity prices and inflation. “This has provided a helpful backdrop for Blackrock World Mining recently, with the shares generating a 94% return over the last two years, comfortably ahead of wider equity markets,” he says.
Both Yearsley and McHattie make a case for equity income funds because of the dividend booster. “There is a case for reconsidering the older style of traditional equity trusts with a value tilt, like Bankers Investment Trust or BMO Managed Portfolio Trust, where the managers have reweighted some holdings to position for potentially higher inflation,” adds McHattie.
Finally, if you’re concerned about preserving the real value of your capital whatever the wider environment, there are several trusts in the Flexible sector that focus on doing just that. Investment companies such as Ruffer, Capital Gearing and Personal Assets use a range of assets, including gold, inflation-linked government bonds, global equities with strong pricing power and real estate, to protect against inflation as well as delivering growth, adjusting relative weightings as the situation demands.
At Ruffer, for example, Morgan says the managers are concerned that the central banks will come under mounting pressure to “dial back stimulus” and increase interest rates in the face of sticky inflation, leaving equity and credit markets vulnerable. To that end, “they have increased allocation to protection strategies, reduced the equity component of the portfolio and upped their weighting to long-dated inflation-linked gilts.”
And the good news is that - in contrast to other inflation hedging sectors - these flexible trusts are on the whole trading around par or on very modest premiums.