Don’t worry if you missed last week’s virtual event with Edinburgh (EDIN ) investment trust managers James de Uphaugh and Imran Sattar, you can play back the entire one-hour broadcast here!

In their presentation and answers to questions, Liontrust’s de Uphaugh and Sattar explain how their team’s stock picking and style-neutral approach have powered the UK equity income fund ahead of the FTSE All-Share index in the past three-and-a-half years.

The de-rating of the UK stock market in comparison with the US and global stock markets has caused much debate, but de Uphaugh and Sattar (who will become lead manager when de Uphaugh retires in February) stike a positive note, believing the lengthy selloff by instititional investors of UK equities is nearing an end.

With falling inflation, alleviating the cost-of-living crisis and reducing pressure on consumer spending, the fund managers are optimistic about the outlook, particularly in the case of Edinburgh whose shares at an 8% discount to asset value offer a cheap route into a cheap UK stockmarket.

Can’t watch now? Read the transcript 

Gavin Lumsden:

Hello and welcome to ‘How to Buy the UK on a Double Discount’ a one-hour programme brought to you by Citywire and Liontrust about the Edinburgh Investment Trust. My name is Gavin Lumsden and I’m from Citywire and I’m delighted to have in the studio the past, present and future of this £1.2bn UK equity income fund. James de Uphaugh, it’s lead fund manager, who has orchestrated Edinburgh’s performance recovery in the past three-and-a-half years and Imran Sattar, a recently appointed deputy who will take over from James when he retires next February. James and Imran, very good to see you today.

Beating the benchmark

James de Uphaugh:       

In terms of the slides and the formal part of the presentation, I really like to start presentations with the performance numbers. So here we go. We started and took on this prestigious mandate in the teeth of Covid and you can see on this, a graph and indeed, on the right-hand side of that table, that actually, the numbers are distinctly respectable in terms of absolute terms and also, relative terms. What you see there is that we’ve also managed to nudge in the discount from a distinctly uncomfortable low teens discount, to a still in my view, distinctly compelling level of high single-digit level.      

Obviously, that’s been against a number of backdrops that we’ve had since Covid and I think that speaks to a number of the key points here. Particularly, I would say our flexible style because you’ve needed that to cut the mustard over that period. Obviously, we’ve got twin objectives. Firstly, and the dominant one is obviously, to beat the index. Tick in the box for that. Dividend per share in excess of UK inflation. Trickier, but I’d say the previous one trumps that one. In terms of how we’ve done it. Both Imran and I and the team, we’re very much into a total return approach. So not trying to gear the portfolio too much to get income at the expense of capital.

By doing that, we think we get into a long-term cul-de-sac if you like. The team, day-to-day, we’re really into fundamental deep research that really integrates ESG [environment, society, governance] throughout. We’re lucky at Liontrust and indeed, at our predecessor company, to have some really good risk management tools. You don’t get the previous slides without a degree of real deep risk management. Obviously, what we’re keen to do is make sure that the portfolio is decently active because the game here is really to attack the market and beat it ideally over three-year periods. We do that with a mix of 40 to 50 stocks.

Including a smattering of rifle shot international stocks which can come up to 20% of the portfolio. Obviously, and we’ll no doubt be talking a bit about this in questions, after this first phase of the rehabilitation, the three and a half years, which I’ve led with the team, Imran is going to be taking over the baton if you like, in early 2024. We’ve worked together for a good old time and I’m confident that that succession is going to work well for the next phase of the trust.

Now, in terms of investment approach, if I just encapsulate this, we spend about a quarter of our time really thinking about the macro. Ideally, trying to think about the tailwinds that are building and avoiding the structural or indeed, the building headwinds. Obviously, today, we’re talking about a period where actually, we’ve got another chapter in this disinflationary period which we’ve seen in the UK and that’s a positive if you think about it. There’s a positive for the consumer because inflation, the energy bill, which was on the jugular of the consumer is obviously reducing and we’ve seen that in the stats today. That means that real disposable income is rising. Yes, we’ve got a building mortgage headwind, but I think the real disposable income effect really dominates things.

So actually, it’s not a bad environment for the consumer. That’s point one. Then the other angle is, what we think we’re going to see is we’re going to see us produce, in the UK, a modicum of growth. It’s not going to be great, but a modicum of growth. Actually, that’s not a bad environment really, for many a corporate because actually, relatively slow growth, if you’re a number one or number two in an industry, it’s very tough for new entrants to come in. So, if I just illustrate that by thinking about one of our bigger positions and we’ve got quite a lot of stocks in the retail sector because it’s been a very interesting area and I think, is still very interesting.

M&S is really changing

If I talk about, for example, M&S (MKS), which I think a lot of viewers will have opinions on and all the rest of it. They had a fascinating CMD. One of these capital market days. All singing and all dancing, where you get a real appreciation of the middle management, if you like, leading the cultural change there. For viewers, it’s really worth clicking on the investor website and getting a feel for that. M&S is a business which is really changing. If you look at the two big divisions, clothing and home and food, both gaining share against weakened competition and they’re gaining share in the right way.

Cost saves and forecasts, I think are low. The business has momentum and the rating and expectations are still quite low and there’s a really interesting angle that I don’t think is yet in the share price. If you were to mark them down, it is that the Sparks angle, the digital angle, if you compare and contrast that with, let’s say, Tesco Clubcard, it’s not particularly clear why you would actually give your data to Sparks. So that is an angle that’s going to come in the future. Meanwhile, the rating is low, the momentum is strong. Obviously, for all the 50 stocks, 40 to 50 stocks that we have, we’re looking to develop a thesis akin to that.

Cheap UK will come good

In terms of the setup for the UK equity market and there’s been a lot of column inches written on this. It’s mostly a bit pessimistic, but I would see the positive in that entrenched pessimism, that is actually incorporated already into valuation. History is history, but I think it’s really important to think about where we were a year ago and I’ve put here, The Economist cover, if you like, of where we were. It felt pretty ugly with that experiment we had from the past, Trussenomics and the like. Now, it’s very different. Business confidence, I’ve chosen a long-running survey from Lloyds.

It’s not blazing, but it’s okay and it’s a level that actually, if you’ve got a good business that’s producing reasonable returns on capital, you’re actually going to have very clear blue water between your pre-Covid trading and now. So very fertile period, I think, to be choosing stocks. Particularly, given valuations are low. Here, what I’ve done is I’ve taken some data from Goldman. They’ve got good data and what it shows is that the free cashflow yield and we could use all sorts of metrics and that shows that the UK is standout cheap. What I’ve learnt and we’ve learnt, is that valuation in the end, trumps all things. What we’re also seeing is buyers come in decent size from the corporate sector and you can see that on the righthand side.

Now, if we segue into what we’ve been doing over the last 12 months to give you a bit of a feel for things. So, you can see there, M&S is there. Admiral (ADM). What you can see there, Admiral is obviously, a motor and household insurer, but what I think is interesting about Admiral is they’re a business that uses data really, really well. In a cyclical industry, the use of data, really trying to keep hold of what claims inflation might be compared to your rate, they’ve done very well. Their results are chalk and cheese compared to Direct Line (DLG).

What we’ve also done over this period is sold some of the more staples that are beginning to run out of road. So the likes of Reckitt (RKT), you can see there, is a big sale. It might be a good time, perhaps, to pass the baton to Imran to talk about a purchase or two and take the presentation on.

Haleon shines

Imran Sattar:                   

Thanks, James. We’ve been buying a position in a company called Haleon (HLN), which is a consumer health business that we demerged from Glaxo (GSK) about 18 months ago. This is a really interesting business that has a bit of a structural tailwind to it. A really nice growth, really good margins. It’s really well set to continue growing really nicely over the next few years. It has some fabulous brands like Sensodyne and Corsodyl in oral care. Centrum in multivitamins and Voltaren in pain relief. Of course, that’s the past, it’s done a really good job. In the future we think there’s more to come. Not least because that demerger from Glaxo will, I think, unlock some commercial execution improvements and innovation.

We really like innovation because it’s one of the things that can sustain very good topline growth. So yes, this business has done a good job in growing its topline, its revenues, but we think there’s more to come. James talked earlier about having a well-diversified portfolio of 40 to 50 stocks, but the trust is also very well diversified by thematic. I just talked about Haleon, that is a really good example of a business that’s driving new product innovation that sustains that growth into the future.

Convatec (CTEC), again, a medical and surgical equipment business. Again, driving new product development that’s sustaining its revenue growth. Innovation driven growth, we really like that.

Data diggers

Perhaps, before I hand back to James, one more thematic that features in the portfolio, data, and analytics. It’s really at the heart of many of the businesses that we own in the trust. Be it Admiral, as James just mentioned. Really utilising data very cleverly, to drive better outcomes for insurance profits. Weir, again the same. Dunelm (DNLM), the retailer, it’s a very well-run business, but it’s increasingly utilising data to better personalise and attract new customers. In fact, James and I attended the capital markets day last week and met the tech team. Very, very impressive.

James de Uphaugh:       

Thanks, Imran. Before we go to the next slide, just quickly look at this slide because I think it speaks for how we’re looking to structure the portfolio. At any point in time, I think it’s important to keep the momentum of the portfolio, if we do structure and layer the portfolio by theme. So, I’ve labelled, with my colleagues, some of these themes and we’ve got Darwinism, which is this idea that the strong get stronger. So, think about Premier Inn’s competitive set. You’ve got the walking wounded in Travelodge. You’ve got family-owned businesses struggling to come back from Covid. New supply just ain’t happening because construction costs are there.

So, we were talking on the walk here, net result is you struggle to get a Premier Inn room below £200, basically. That is the reality and yet, that price point still is only a small premium to the likes of Travelodge. So, the likes of Whitbread (WTB) have a clear runway of growth.

Banks are better

ESG rehabilitation. We might come back to this, but the key point is that what I’m really looking to illustrate is that ESG is not a static thing. It’s something that iterates and I think one of the best illustrations of that is actually, the banking sector. So, the banking sector’s been on this long march wearing sackcloth and ashes from the GFC, for good reason, frankly.

Regulators have forced them, quite rightly, to hold much, much more capital because we can’t have a repeat of what we saw 2008, 2009. If you think about how they performed in Covid as purveyors of new loans and if you think about what the world needs to do in terms of transitioning, we need to spend huge amount more. Particularly, actually, if I could use that cliché phrase, in the developing world and actually, the likes of HSBC (HSBA) and Standard Chartered (STAN) as fantastic ringmasters for that in putting these big, big projects together. Putting investors, export agencies and the like, together.

So key thing is layering the portfolio with themes to keep that momentum going. This is quite a dry slide, actually, but what I really want people to take away from this is actually, the scale of the relative bets, on the right-hand side, that we take. It’s rare it goes above 5% and, also, this is orientated mainly towards the FTSE 250 with again, a smattering of rifle shot international shares. So, in term of concluding. We’ve completed the first proof point. You can see from our first slide, that the numbers are good, ergo the flexible process works in the investment trust world.

We’re lucky enough to be ploughing our trade if you like, in a market that is demonstrably cheap and even luckier to be doing it in a vehicle that actually, also trades at a discount. So, if you like, the way I think about it is we’ve got this compelling double discount. Hence why we’re here.

Where we added value

Gavin Lumsden:

James, Imran, thank you very much. Lots to pick up on there. Do start sending your questions in. I’ve had one or two in already and that’s fantastic. I’m going to ask our fund managers some questions now, but if you’re thinking of anything, do pop it down and send it in. Starting with you, James, you and your co-manager, Chris Field have done an excellent job for Edinburgh shareholders since taking over in March 2022. That was quite a time. While your retirement isn’t, perhaps, a huge surprise after a 36-year career, did you have any qualms about leaving the post after a relatively short period?

James de Uphaugh:       

One obviously navel-gazes about how share owners would react, but the way I think about it is, we’ve had this first three-year period. As you say, the numbers are good and we’re lucky enough to have a strong team with Imran leading in 2024. I think now’s the right time to pass the baton to a new leader who will actually use the same process to drive the next phase if you like, of this venerable trust.

Gavin Lumsden:

Looking back at the outperformance you’ve achieved, was your timing lucky, given you took over during the pandemic crash? In the recovery, where did you add the most value do you think?

James de Uphaugh:       

I’m smiling because as we decamped, it didn’t feel hugely lucky, but obviously, in absolute terms there’s a degree of luck. I think the relative speaks to a degree of manager skill, if I go into consultant-speak. I think also, when a manager is appointed to a trust and I think this is an important point for viewers to take on board, there is an incredibly exhaustive due diligence assault course that you go through. What happened was that the team and my numbers, were put through the statistical ringer, dating back to 2006. So that’s a period where a manager’s record does demonstrate skill and we’ve got a tick in the box for that.

Wonderful Weir

The specific question on where did we add most value over the period? It’s a lovely potpourri of different stocks, actually. It’s the likes of Centrica, BAE Systems, NatWest (NWG), Ashtead (AHT) and Weir (WEIR). These are all very different types of stocks. So, it’s not mono-theme if you like. I think Weir’s a particularly interesting one because I remember vividly as a team, deciding to buy that because here was a stock that was being thrown out with the bathwater effectively. I think why it was, was-.

Gavin Lumsden:

A maker of valves for the oil and mining sector?

James de Uphaugh:       

Yes. So, this is a fantastically venerable company that was founding in the 1850s. Glaswegian company. As you rightly say, it was in the foundry business and now, it does these incredibly big pump systems and it also does what are called ground engagement tools. If you think about the big mining diggers. Mining now, is so much about data really. If you Google a Rio Tinto control centre, you’ll see computer screens like a dealing room because what they’re trying to do is predict where the high quality ore is. Weir’s ground engagement tools, however absurd it may seem, these teeth have sensors on them which actually try and work out where the high grade is.

It’s an incredibly complex business and data driven business. Anyway, I digress. The key point I wanted to say was that here was a business that, on the face of it had oodles of leverage. Our analysis showed that actually, here was a business that by selling the counter that was the shale business, it could move from beyond the pale for most fund managers, into the nirvana territory and we were able to buy with a seven handle, it now has a 17 handle and is a great business.

Gavin Lumsden:

You turned to Imran at that point, we’re talking about Weir. Imran, were you involved in the analysis at that point?

Imran Sattar:                   

It was very much a team effort. That is how we think about investing on the team. The idea generation may come from one of the team members, but I think the hurdle is high to make the cut. We all have to believe in it. So, I absolutely concur with James’ views on Weir.

Gavin Lumsden:

So, you’re new to many of us, but you’ve been in the background all this time. That’s interesting to know.

Dropping tobacco

James, turning to the dividend, you’ve got a total return approach, but in terms of the income, were you right to drop tobacco stocks when you took over?

James de Uphaugh:       

I shouldn’t really hesitate, I should say, yes. Actually, if you look at it through the lens of BAT (BATS). BAT is pretty much, the same price as it was then. Yes, you’ve had the dividends, but in terms of total return that would have been a millstone round the fund. I think the longer answer to that is, for much of our investment careers, the game for tobacco companies has been you can stomach minus three on your volumes and you put price up four. What’s happened more recently is it’s got uglier. So Imperial, I think yesterday, had a minus seven in their volumes. BAT tends to have a minus seven as well and it’s pretty difficult to get eight plus on your price or mix.

So, the P&L algorithm is beginning to break on that one and the other awkward thing with these businesses. They’re trying to transition to reduced risk product and, also, they have lashings of debt. So, BAT has of the order of 2.8 times net debt to ebitda [underlying earnings] and Imperial (IMB) has 1.9 times net debt to ebitda. These are uncomfortable numbers if your algo is not working perfectly. So dead content not to have these tobacco companies.

Dividend prospects

Gavin Lumsden:

Okay, just testing the conviction there. Are you more positive on prospects for dividends and revenue than you were two or three years ago?

James de Uphaugh:       

I think if there was a good side to Covid and we obviously all struggled to think of a good side. For the UK equity market is was a dividend policy clearing event really. Anyone who was over distributing had the perfect excuse to take a pause, recalibrate and start again. So, I think a lot of that happened. So, the answer is, yes, but not rabidly so. Obviously, our aim is to find companies who, through a mix of investing strongly in their business will produce naturally, off the cashflow statement, a good dividend flow. What we’re really after is companies that, if you like, the dividend isn’t a feudal tithe. It’s more something that comes off the P&L naturally. If we find those companies, I think we’ll do very well for the trust.

Where are we in the recovery?

Gavin Lumsden:

I think a question that’s on a lot of peoples’ minds is, where are we in the early stages of the UK recovery? As you’ve been saying, the pulse of the economy has been quickening and so far, we’ve avoided recession. The inflation figures out today are falling and encouraging, but there appears to be no end to the investor exodus from the UK stock market.

James de Uphaugh:       

So, it’s been quite a long march of selling, I think, in reality. Pension schemes used to have 40% to 60% in UK equities. Now, if you click on the Tesco pension scheme annual report or the Nest pension scheme, you might see 3%, 4% in UK equities. So dramatic change, but I’d say that’s happened. The next one is wealth managers. Wealth managers have also been reducing. I think they’ve been chasing the MSCI upwards and the UK is only about 4% or so, of the index. So that has also been weighing on the UK equity market. I think politics has as well, but we’ve had our flirtation with extremes over the last few years, in a way that perhaps, many other countries have not. I think that is relevant.

I think the other side of the equation is, is that corporates are buying in, in spades. I know that I would much prefer to be close to the corporates in terms of that decision-making than the previous cohorts, which I’ve just referenced. I think the last few days, actually, have been fascinating. We’ve seen good inflation stats as you rightly say, from the UK today. We saw good inflation stats from the States yesterday and that really lit the touchpaper of the UK equity market and the shape speaks for some very skinny positioning, I think, in UK equities. So, when people begin to give up, it’s actually just the time to be getting interested.

What’s going on with gearing?

Gavin Lumsden:

In which case, my last question for you for now, gearing, the borrowing that the trust has, that you have to invest, looks a bit low at just over 4% net of cash. Does that indicate your caution? Could that figure change if the turnaround you’re talking about occurs?

James de Uphaugh:       

Gearing, I think is another quite good story for the trust because like a lot of investment trusts, we had these debentures which were cast a long time ago. They had a seven handle in term of coupon. Actually, the board and my colleague, James Mowat, did a roadshow, made a decision. We recalibrated, we refinanced that debt at 2.42%. So, this is debt that goes out for 25 years in lots of different tranches.

Gavin Lumsden:

You’ll be paying two and a-bit percent every year.

James de Uphaugh:       

Yes. If you think about where ten-year gilts are. They’ve got a four handle. This is a stellar positive, I think, for the trust. Now, your question on the 4% to 5% of gearing. Actually, that’s a technicality. The way, actually, the debt works is we have £120m of debt at par, which I and Imran can use and we’re pretty much, fully using on an NAV [net asset value] of about £1.1bn. So, you might think of debt at 10%, but the way the investment trust industry values debt, it values them at fair value, which is off gilts. So, the value of the debt has gone down. So, in theoretical terms, it’s about 5%. Actually, we’ve got prudent levels of debt and it’s actually been cast at stupendously low levels, which is great.

Gavin Lumsden:

The price of the debt of the bonds that you’ve issued has actually come down so that’s reducing the NAV and reducing the-.

James de Uphaugh:       

No, it’s increasing the NAV.

Gavin Lumsden:

Increasing the NAV, but reducing the size of the debt and as a proportion it looks smaller. So the gearing looks lower than it actually is?

James de Uphaugh:       

Yes. Well, it depends how you think about that. The way in actual fact it works is, every year we have £120m of debt at 2.42% that we can use, hopefully, to improve returns for the trust.

Gavin Lumsden:

That’s £120m out of a £1.1bn portfolio.

James de Uphaugh:       

Yes, so nice level. About 10%. The sort of level you’d want.

Gavin Lumsden:

It’s long-term debt, as you say, may as well get this clarified. The viewers are interested in this. You can dial down that £120m by holding cash to offset that.

James de Uphaugh:       

Yes.

Gavin Lumsden:

So currently what’s your cash position?

James de Uphaugh:       

So, the cash position at the moment, is £10m. So, we are using 90% of the debt.

Imran is ‘growthier’

Gavin Lumsden:

Brilliant. Thanks, James. Imran, over to you. Congratulations, you’re about to become the lead manager of the trust in February. Can you tell us a bit about your career and how you approach investment?

Imran Sattar:                   

Of course. Thank you, Gavin. I’m very excited about leading on the trust early next year, but importantly, supported by the wider Liontrust team. I’ve been managing UK equity portfolios for over two decades now. I worked for BlackRock for 20 years before joining Majedie, which is now part of Liontrust, back in 2018. Like James, I’m very much a bottom-up stock picker. That’s what really gets me going and in practice, what that means is hunting for businesses that have a bit of a competitive edge. An economic moat, as I like to call it. Companies that have a bit of structural growth, tailwind behind them. These are companies that are generating high returns on capital and the key is, is can they sustain those?  That’s where the moat comes in.

Gavin Lumsden:

You’ve managed a fund called Liontrust UK Focus, that’s an opened-ended fund. It’s also a concentrated, high-conviction fund like Edinburgh and avoiding style biases. I did wonder, looking at it this week, with top holdings such as 3i Group (III ), are you a little growthier than James or are there any subtle differences that we might expect going forward?

Imran Sattar:                   

Of course, no two fund managers are created equal, but there are more similarities between us than differences. We both share this passion for bottom-up stock picking and that’s what we’re about. Beyond that, I think it’s very important to have a flexible investment process. We’ve both seen lots of cycles between us. Be it the internet boom and bust, the GFC, Covid, the recovery from and lots of mini cycles in between and I think to be able to cope with those stock market cycles, you do have to have a flexible investment process. That said, I am a little growthier. That is fair. I do like businesses that have that structural tailwind behind them and that economic moat.

BAE and ESG

Gavin Lumsden:

Let’s talk about some of the stocks that you’ve got. Some of the key stocks. James, BAE Systems (BA), can I just clarify. It’s a top holding, but it was down on the slide as a sale. Is that a full sale, a partial sale?  Were you taking profits? What’s going on?

James de Uphaugh:       

The shares have performed very well. It’s a very strong structural growth story there, I think. We did trim the holding so, it’s right to put it down as a sale, but it’s a partial sale.

Gavin Lumsden:

It’s done very well since the outbreak of the war in Ukraine last year and trading appears to be very good. The shares have doubled in that time. I was also wondering, on that slide you had it under an ESG rehabilitation theme. How does a defence stock fit into ESG and social investing?

James de Uphaugh:       

I think it’s a very complicated area, really, isn’t it. We’re obviously having this conversation in London and I think if we were having it, perhaps, in Stockholm, I’m not sure we would think about that so much. I think the reality is to have a strong democracy and have strong institutions, to have peace and justice, you do need a defence capability. The key thing is to ensure that that defence capability sells under government deals, which BAE Systems does. I think if you look at the UN SDGs [sustainable development goals], number 16 is exactly that. Peace, justice, and strong institutions. So, I’m very comfortable with that.

You referenced Ukraine, but I think the world is a more complicated place. There are many, many areas where, actually, you need to be strong. I think if you look at it through the lens of BAE, there’s a lot of focus on Ukraine and yes, they are selling a lot into Ukraine via the US, UK, and other nations. Actually, the longer-term-, and BAE is a structural growth story, with a strong, deep order book and strong moats, the longer-term actually is often really about Asia effectively. So, if you think about what’s happening with Australia, with AUKUS deal or indeed, the next generation fighter, which is a joint venture between Japan, Italy, the UK and possibly Germany. These are multi-decade contracts that I think are good for world dynamics and, also, good for shareholders.

Gavin Lumsden:

So strong business and the ESG rehabilitation is referring to a reappraisal of the social benefit of defence stocks. That they’re doing military goods in a fairer way or something.

James de Uphaugh:       

I think we’ve just had a reappraisal of the need to have a strong defence force.

Is Capita still cheap?

Gavin Lumsden:

Let’s turn to Centrica (CNA). Your highest conviction stock, I think, from what we saw earlier. In your third-quarter update, you referred to one of these CMDs, successful capital markets day in the City, when they were talking to investors. In which they said in your words, ‘They were clearly undervalued.’  The shares, I think, were up 65% this year. Is that really the case?

James de Uphaugh:       

Yes. I mean, I think the shares have gone up a lot under the new management and I think this capital markets day laid out some ranges of profitability for the key divisions. You can calculate from that, that the underlying earnings, medium term for the business, is in the order of 11, 12 pence. There’s net cash of 40p and then as they reinvest, you might get another 40p. So, they’ve move up a chunk and they’re in the 145, 155 level. We’ve sold a bit because as you rightly say, it’s quite a chunky holding for us. It’s still one that we have medium-term conviction in at this level.

Diageo’s profits warning

Gavin Lumsden:

Imran, turning back to you on Diageo (DGE). It’s been a big contributor to the trust’s performance in the past three years or so. It had a serious profits warning this month. I just want to get your reaction to that and whether you still own it.

Imran Sattar:                   

We think Diageo is a world class business that has structural growth, fabulous brands, fabulous market positions. We think in the long-term it’s a very good business. James did a fabulous job in selling the position down to zero about 12 months ago in the mid-£30 level. Of course, some of your viewers will have read that there was a profit warning last week. James and I were worried about downtrading risk, particularly in the US and trading has been weak over the last 12 months. Perhaps there’s more to come, bit it’s now firmly back on the radar because we do think it’s a very good business and it’s derated. As it happens, there’s a CMD in New York this afternoon, which we’ll be dialling into. So perhaps more to come on that one.

How does that affect Unilever?

Gavin Lumsden:

Its warning’s centred around its Latin American and Caribbean business, particularly, which is 11% of the group. I just wondered, does that have a bearing on Unilever (ULVR), which I think you do own as well?

Imran Sattar:                   

That’s a very good question. I’d say first off, Unilever’s categories are a little less cyclical. That’s the first starting point and then the second is that the level of premiumisation at Unilever is lower versus Diageo. I think there’s less scope for downtrading with Unilever. That said, there have been some execution missteps from the business. That’s why, I think, the earnings growth has been pretty limited over the last two or three years. We’ve been disappointed by the execution and James has sold the position down a little bit in favour of companies like Haleon.

We do think there’s an interesting story there, potentially. We’d like to see a bit more evidence of that and the new CEO laid out his plan, Schumacher, and we think there’s potentially some upside in the future, but at the moment, we’re a little bit concerned about execution. Specifically, the number of products that are taking market share. It’s at a really low level and we’d like to see that improve before we get a bit more interested in Unilever.

Gavin Lumsden:

A bit more growth there would be good. That’s my questions for now. Do keep sending yours in. We’ve had a good number in and I’m going to start with a question that Jason Nightingale sent this in before we started broadcasting. We may have to come back to you on this, Jason, because I didn’t flag this up with my guests ahead of time and it’s quite a technical question, but it’s going back to the gearing and the debt we were talking about, particularly around the dividend first of all. ‘What are the revenue reserves supporting the dividend at Edinburgh?’

James de Uphaugh:       

As you say, Gavin, those are laid out in the annual report and we’ll have to come back to you on that. I think the key point I would say about reserves, which the question alludes to, is how dependent is your dividend on reserves? Here again, the story is good with this trust. Actually, if you look at the historic last year’s dividend, 26p or so, actually 97% of that was from the underlying dividend flows. So, in my view, it’s a high-quality dividend that is not dependent on depleting reserves.

Gavin Lumsden:

I think actually, I had a quick look at the accounts. Jason was asking, ‘What’s the revenue reserve per share?’ We’ll have to come back to you on that, Jason, but I think the actual total sum was just over £51m at the end of March, according to the annual report. Jonathan Thompson dropped us a line to say, “In terms of income, how does the split of income between the UK and the non-UK compare with the FTSE100?”

James de Uphaugh:       

When sterling appreciates, the trust tends to do a bit better. So that would indicate that we have a slight bias towards sterling is the answer to that.

What is your active share?

Gavin Lumsden:

So more non-UK income than UK. Mark Partington is asking, ‘What is your active share?’ Can you define what active share is, first of all, for anybody who doesn’t know and what is it?

James de Uphaugh:       

Active share is your difference from the index. So, you’d define it, basically, zero is exactly in line with the index and we are high 60s at the moment.

Gavin Lumsden:

So, income funds often do have a bit of an overlap with the benchmark and you’re investing three-quarters, roughly, in FTSE100 stocks. You’re holding 50 stocks rather than 100.

James de Uphaugh:       

What I’d say is, palpably the numbers indicate that we are running an appropriately active portfolio. If you think about that first slide that we had, that would indicate that the portfolio is appropriately active.

The catalyst for recovery

Gavin Lumsden:

Nicholas Parr, coming back to the big question around potential catalysts. You’ve talked about this already a bit, but maybe you could say a bit more in terms of his question. ‘What do you see as the catalyst to drive a rerating of the UK market versus the US or Europe? What about timing if that’s not the impossible question?’ he asks.

James de Uphaugh:       

This is almost the classic question. What’s the catalyst? It’s very difficult to put one’s finger on an exact catalyst, which arguably is frustrating, but in a way, if we could find that catalyst, it probably would have happened already. I think and I come back to what I said earlier, I think that actually in the end, valuation trumps everything. The key thing is it’s a question of when. What I’d also say is that much of the selling has already taken place. We talked about pension schemes. You asked about wealth managers. Private investors. They’ve been selling for 24 months.

The other side of the equation is corporates are lapping up the equity and I’d much prefer to be on the side of corporates than those previous three cohorts. So, I’d say to your questioner, be patient, it will come.

Imran Sattar:                   

The only thing I’d add perhaps, is that 12 months ago or so, when we had the Trussenomics experiment, it was pretty difficult to say that the UK economy was not a bit of an outlier. Where we are today, is that when we look at GDP versus pre-Covid, versus other European countries, we’re in the pack. I’m on shaky ground when I talk about politics, but again, I’d probably say that the move to the centre, again political risk not at extreme levels. So, the UK economy is in the pack versus being perhaps, rightly so in a difficult spot. In September last year. I think that warrants a closure of the discount. Ultimately, economics do win.

Philosophy unchanged

Gavin Lumsden:

Andrew Moffat’s asking about the change in management. About your arrival. He asks, ‘What assurance can you furnish to suggest that the excellent performance since the change in management over the past three years or so, will continue under the new manager? To what extent is the trust managed on a collegiate basis rather than an individual basis?’

Imran Sattar:                   

James has done a fabulous job, of course. So big shoes to fill. I’d say that it’s the same team that’s managing the assets, it’s the same investment process, the same philosophy. That total return philosophy that’s served the trust so well over the last three and a half years. That is not changing. I guess, I’m also in the fortunate position that I inherit a very well-set portfolio. Don’t expect wholesale change at the portfolio level because this portfolio’s full of advantaged businesses with some very nice structural tailwinds. It doesn’t need huge change. Will there be some sock specific changes? Of course, but the broad portfolio construct will not change.

Will a growth tilt hurt the dividend?

Gavin Lumsden:

Picking up on that a bit is Shawn Parker, Imran. He’s asking, ‘If you tilt the portfolio a bit more towards growth stocks, will this lower the dividend revenue generation going forward and therefore, risk the dividend?’

Imran Sattar:                   

The philosophy, as I said, is very much about total return. Could the dividend yield of the trust be a little bit lower?  Yes, perhaps at the margin. Of course, we talked earlier about the very strong reserves that the trust has, but again, it goes back to the philosophy of driving total returns. We don’t want to be stuck in yesterday’s businesses like British American Tobacco, we want forward-looking businesses like many of those we’ve mentioned today.

The thesis for Mondi

Gavin Lumsden:

Some questions on some stocks. John Kingham spotted Mondi (MNDI) at the top of your thematic pie chart. ‘What is the investment thesis for this paper bag manufacturer?’

James de Uphaugh:       

It’s much more than a paper bag manufacturer. So, Mondi is a business that has, over the last 15 years or so, just set up an amazing network of low-cost paper intermediate businesses which do everything from the cement bags to-, those of you who’ve got pets, you’ll know that pet bags meld between plastic and paper. They’re really at the nexus of technology, I think, which is obviously, we’re trying to reduce the use of plastic in our daily lives and use paper where we can. The interesting thing about Mondi is that again, most of its plants are on the top or second cost quartile.

So that means that they’re advantaged businesses and they’re often competing against businesses that are very, very leveraged. So, this is a business that I think in an upcycle will make decent returns just as they have. They’ve also got a very strong capex programme and, in the past, they make decent IRRs, return on capital in those. So, I think Mondi is a good business. It’s obviously been through this slight air pocket because it had to dispose of its Russian business.

It’s actually done a bit of a Houdini there. So, it’s one of the few businesses that’s actually managed to get some cash out of Russia. This Siberian business has been sold for a decent amount, so shareholders will get cash from that. It’s a tightly managed business with very, very strong positions on the cost curve and one I like, we like.

View on housebuilders

Gavin Lumsden:

Mark Partington’s come back with a question on housebuilding. ‘What’s your view on the housebuilders?’

James de Uphaugh:       

I think we had a great meeting with Bellway (BWY) the other day. I think the key thing and this was about two months ago, they were saying we need mortgage rates below 5%. Actually, we’re kind of there. So, the backdrop for the housing market has improved potentially enormously. We’re not seeing that yet, but potentially enormously. I think the next 12 months or so, are going to be difficult because we’ve also got a general election coming up in autumn of 2024. If you are in the likes of Bellway or Redrow (RDW), which in the case of Bellway, you’ve got a great landbank that is ready to roll when demand comes back. Trading at a discount to NAV.

In the case of Redrow, slightly differentiated product. Perhaps a slightly higher price point than Bellway and I think both of those, which trade at-, particularly Bellway, trade at discounts to NAV and have pretty good dividend flow, actually, in the case of both of them. They are ones which-, we’re very price dependent, but I think are ones that have decent upside.

Gavin Lumsden:

Imran, sounds like they could be on your radar, is that the case?

Imran Sattar:                   

Yes. It’s a tough market, there’s no doubt about it, but the second derivative is improving and we think that hopefully persists for a while. I think we’ve got to brace ourselves for a tougher period, but our focus has been very much on the long-term and Bellway’s done the classic. Let’s buy the land bank at really good prices. It’s stored up gross profit potential for the future.

Gavin Lumsden:

Nicholas Parr’s come back with another question as well, which is great. We’ve touched on ESG. The environment, society, governance. He’s wondering, ‘Are there any sectors that you exclude from your approach?’

Imran Sattar:                   

We think that ESG has to be a bespoke-, our philosophy’s very much a bespoke way of approaching ESG. So, we look at the merits. The risks and the opportunities and create a materiality assessment and think about how companies are coping with some of those risks. You cannot judge the same criteria for Shell versus Dunelm. There are different things that matter. So, it’s important to have that nuance, but we don’t exclude any sectors.

What’s your skin in the game?

Gavin Lumsden:

Couple of questions coming round on your personal positions. Do you have skin in the game? James, I think we know you do, but what’s the answer?

James de Uphaugh:       

The answer is it’s over a million quid.

Gavin Lumsden:

So, a decent chunk. Imran, are you currently investing or will you be? What’s the situation?

Imran Sattar:                   

I certainly will be, come the new year.

Gavin Lumsden:

That’s great. Andrew Moffat, who asked that question actually, he just says, ‘I want to take this opportunity to thank you personally for your stewardship of this trust.’

James de Uphaugh:       

Thank you, Andrew.

Gavin Lumsden:

Which he bought into when you took over.

James de Uphaugh:       

I have to say, it’s been a lot of fun. So, thank you, Andrew.

Are there political risks?

Gavin Lumsden:

It’s been a success story, which is nice. Well, we’re getting close to our time, but you’ve alluded to Trussenomics and politics. We’ve got the election coming up. So, what’s your view on the potential change in government? Labour’s well ahead in the polls, etcetera. Is there any political risk to this UK recovery?

James de Uphaugh:       

Perhaps if I plunge in first. I think the broader perspective is obviously, our politics being very complicated. If you think about it, the previous Labour leader was in economic terms, considered to be a little bit extreme. Obviously, the previous conservative leader was considered to be a bit extreme. If you like, we’ve ticked both of those off and now, actually, we’re a phase where actually, politics are pretty similar if you look at the politics. Yes, there’ll be different nuances. I think the risk really, in an election, is that it leads to a bit of an air pocket in trading for some companies in the run up to an election.

I think more generally, and we speak to a number of companies, actually, the Labour government is engaging with the utility sector, the housebuilding sector, the banking sector in a very cogent way, that actually, many companies are finding pretty positive. I thought it was quite interesting that I think the Labour government or the Labour government in waiting, had a big conference and they sold tickets. I think they sold tickets at about a thousand quid a pop and it sold just like that. It wasn’t quite Glastonbury, but it was pretty close in terms of selling out. I think that speaks to the engagement from the corporate sector.

I think the other point is that it’s a well-trailed stat that 40% of the world’s GDP and 40% of the democratic world is having an election next year and if I was to rank countries where I’d be worried about election, it wouldn’t have the UK at the top of the list.

Gavin Lumsden:

Imran, you’re the one who’s actually going to have to deal with this risk of whatever form it takes, are you sanguine?

Imran Sattar:                   

I did say this is shaky ground for me. With that caveat, I’d just say James is absolutely right. That move to the centre is something that’s very comforting for me in terms of the outlook for the UK equity market. It’s a lot of risk to think about. At company level, at the sector level, at the macroeconomic level. Not having to think about the potential tail risks from policy, I think that’s really very encouraging. So yes, I am sanguine.

Will you buy more international stocks?

Gavin Lumsden:

Just sticking with you just as we’re approaching the end of our time. You’ve got a bit of a global equity background. I was just wondering because of so much value in the UK stock market at the moment, your overseas exposure of the trust has dropped around 8%. Is that something that you might increase?

Imran Sattar:                   

I think in time, having that flexibility to invest up to 20% of the trust assets in non-listed shares is very valuable. We know in the UK equity market that there are some gaps and technology and maybe, healthcare is a couple of areas where there are some gaps. I think there’s some really brilliant businesses in much of Europe and the US that can potentially fill those gaps. Where we stand today, both of us are seeing some fabulous opportunities in UK listed shares and hence the weighting is at the low end of the historic range, but expect that to rise. It’s going to be very stock specific and opportunity driven.

Gavin Lumsden:

We will await with interest to see what happens there. In terms of the banks, I’m wondering. James was talking earlier about they’re financially stronger than they were back in the crisis of 2008. So, they’re safer, but are they better in terms of the way they treat customers? They’ve had to deal with misselling provisions and risks over the years. Those have come down, but there’s always a danger that they mistreat their customers or have they change their spots there too?

Imran Sattar:                   

I think there’s always that risk, of course. They’ve had 15 years of a regulator on their backs, and I think that does make a big difference culturally. So never say never, but I do think that they’ve made enormous strides in terms of improving their internal processes. The tech platforms, I think, just positions themselves to be better stakeholders and I would not underestimate the technological progress that these businesses have made. Of course, the other thing is that their balance sheets are very, very strong. So, James is absolutely right.

Gavin Lumsden:

Last question from me today. We’re speaking online and you’ve referred to CMD, these capital markets days that companies have. Are they having more of these? Is there a bigger effort to communicate with investors both corporately and by fund managers?

Imran Sattar:                   

That’s right, Gavin. There’re the usual results roadshows, where we meet, on average, a company twice a year and there, we’ll discuss the results from this period. For the last six months, for the last 12 months. Delving in to the detail, the culture of the business, what are the key drivers in the long-term. That’s where you can get a lot of information at these CMDs. Just in the last week or so, we’ve done three of them and there’s one this afternoon from Diageo, as I mentioned earlier. We think they’re very, very valuable. The other thing is, is that you really get to meet the next layer of management team down. The people that are actually running these businesses. So, we find them very valuable.

Gavin Lumsden:

Thank you, Imran. That’s all we have time for today, but thank you for watching and sending in all your questions. A reminder to please complete the feedback survey, as we’re always keen to improve what we do. Thank you also, to our two fund managers. James, enjoy your remaining months on the Edinburgh Trust and best of luck in your future endeavours. Imran, very good to meet you and look forward to meeting again in the future. This is the last of our investment trust programmes this year, but we will be back in 2024. In the meantime, keep reading the Investor Trust Insider website and happy investing. Goodbye.