Many investors were probably quite happy to wave goodbye to 2022, which was a very difficult year, albeit perhaps wider world events over the same period helped give us all a bit of perspective on that. After a muchneeded break, a little bit of optimism crept into markets in the New Year, with some of the most popular stocks and sectors of the last five years bouncing back quite significantly for a short period. But rather like the credit card bill for Christmas dropping through the letter box, investors were reminded in March that rising interest rates can have a profound effect on the value of assets and that there are potentially far-reaching consequences.
We don’t need to go over all the details of Silicon Valley Bank here, except to say that its undoing was explicitly linked to rising interest rates combined with a touch of overconfidence. It is also a timely reminder that problems with companies can sometimes take a little while to show up, and it’s important not to be too complacent that the market has priced in all the so-called unknown unknowns. As such, we think it’s a bit early in the year to draw too many conclusions from what’s done well compared to the previous 12 months, as we know that investors often become attached to stocks that have fallen in price, hanging on in the hope that they will recover enough to recoup losses. This perfectly understandable human trait can take a bit of time to work through the system.
Alongside interest rates, a more subtle shift we noticed in 2022 was investor attitude to growth companies. A long period of very low interest rates meant that growth companies could borrow very cheaply and not really worry too much about the cost of borrowing. This meant companies could potentially grow very quickly by investing without having to worry too much about the return on capital from that investment. All this changes when interest rates and inflation rise. At this point readers might already be anticipating a suggestion from us that a rotation from ‘growth’ to ‘value’ investing might be about to occur, but we think the change is probably more subtle than that. High inflation means that investors need growth in real terms and to do so they need to identify those companies and sectors that can grow despite, or perhaps even because of, higher interest rates and inflation.
As a result we would expect a renewed focus on ‘quality’ growth companies. ‘Quality’ is a term coined by Benjamin Graham, often referred to as the father of value investing and although not many fund managers would, of course, go around saying they invested in ‘low quality’ businesses, in this context, ‘quality’ has a specific meaning. Broadly speaking it refers to factors such as returns on capital invested, free cash flow, reasonable valuations as well as more subjective factors such as market leadership and strength of management. Many fund managers, abrdn included, put a great deal of emphasis on identifying quality, and the next few years could be a good time for this type of active management.
Another theme that had an interesting year was environmental, social and governance (ESG). The performance of traditional energy companies, which are often excluded from ESG-specific mandates, was one of the brighter spots in an otherwise very difficult year, and one could be forgiven for thinking that investors might therefore be losing interest in ESG as a theme. Furthermore, there were plenty of critical voices amongst commentators, which we think was generally part of a very healthy debate. Regardless, industry statistics show that investors continued to put money to work in ESG-led investment strategies. Naturally any theme that involves applying ethics to investing has an element of subjectivity, and the framework that defines what ESG really means is likely to keep evolving. What is evident to us is that more objective ESG factors are increasingly interwoven into investment processes, whether or not a particular investment trust is specifically marketing itself under the ESG label. Investment trusts such as Dunedin Income Growth go a step further however, with specific exclusions for certain sectors such as tobacco, defence and fossil fuels. These binary decisions are only part of the story however, with every company scrutinised rigorously for sustainability factors. While some investors may not feel as strongly as others about those exclusions, we believe they should still be interested in these types of strategies for diversification purposes, as they provide access to a different mixture of companies when compared to a more traditional equity income strategy. After all, what investor doesn’t want to invest in companies that are sustainable over the long-term, which is a big part of the analysis that fund managers make as part of their overall ESG process. We also think that some aspects of ESG are aligned with ‘quality’, and so marry quite nicely with the previous paragraph.
Turning to where investors might be looking to next, we should say that Kepler Trust Intelligence has an audience of about 50,000 professional and 450,000 retail investors, who typically invest using one of the D2C investment platforms. Our reader statistics therefore give a good overall sense of where investor interest lies. In the last 12 months, AIC sectors that retail investors have honed in on particularly include Private Equity, UK Smaller Companies, Global Equity Income and Renewable Energy Infrastructure, as well as the Flexible sector. This tells us that our retail readers are a forward-looking group, not necessarily looking at past performance for their cues, but asking the very important question, “what’s next?”
All of these sectors have something to offer: UK Smaller Companies is a sector that tends to perform well in the immediate aftermath of negative economic growth. The Flexible sector covers a wide range of strategies, but we think investor interest is unsurprisingly focused on those that aim to protect capital in different environments, perhaps when equities are doing less well. The Global Equity Income bucket, which includes abrdn’s Murray International with its outstanding long-term track record, provides investors with a great complementary investment, alongside core UK equity income trusts such as Murray Income. Let’s look at some of the above sectors in more detail, together with one other we think is worth a fresh look.
Renewable Energy Infrastructure is one of the big success stories of the last ten years for the investment trust sector, with a group of investment trusts that are a significant part of the UK’s renewable energy sector. Energy security was, and remains, an important theme that came to the fore in 2022, but during the year the sector moved from an average premium to an average discount, where it remains now. Investor concerns that these trusts would suffer an energy windfall tax alongside the traditional fossil fuel energy providers are beginning to fade, but full confidence has not yet returned, and hence many trusts in this sector trade on small discounts, with very attractive dividend yields.
Next, we believe UK Commercial Property has reached an interesting point. As readers will be aware, this is an asset class with a very strong correlation to interest rates. Given this traditional correlation, it was no real surprise that in 2022 share prices of REITs fell in lockstep as the stock market correctly anticipated falls in commercial property prices. At the time of writing, as we approach the end of the first quarter of 2023, there are signs amongst property fund managers that a bit of confidence is returning, and while values may fall a little more yet, large discounts to asset value are probably now too pessimistic. A REIT such as abrdn’s UK Commercial Property REIT offers an attractive yield in the meantime, relatively low levels of gearing and diversification across several key areas of the UK property sector.
Finally, Private Equity trusts such as the abrdn Private Equity Opportunities Trust are trading at very large discounts which, among the most established names, are probably underserved. Investors should not confuse these private equity trusts with venture capital, which typically invests in companies before they turn profitable. Private equity is much more focused on profitable businesses with growth potential, very much echoing our theme of quality mentioned above.
Here at Kepler, we firmly believe in long-term investing and diversification. We also believe that investment trusts offer asset classes and investment styles that aren’t easily available to the average investor, including some of those listed above. You can find plenty of information on our website to help you on that journey. We also know that putting money into an ISA every year to take advantage of all that investment trusts have to offer is a good, long-term habit to get into.
Find out more at trustintelligence.co.uk
Risk warnings you should consider prior to investing:
- The value of investments, and the income from them, can go down as well as up and investors may get back less than the amount invested.
- Past performance is not a guide to future results.