How to find a bear-beating investment blend

22 September 2009

The 12 months following the collapse of Lehman Brothers in September 2008 were a dramatic reminder that markets can swing rapidly from suicidal to euphoric, and that collective investment vehicles that do well in one environment can falter in another.

For this reason, our annual investment trust selections are divided into two sections.

Our aggressive choices are best suited to rising markets. They tend to have concentrated, high-conviction portfolios and to make frequent use of gearing. This left them painfully vulnerable to the indiscriminate sell-off last autumn, but investors who had the nerve to buy into them in early 2009 have been richly rewarded.

Shares in Schroder UK Growth Fund, Edinburgh Worldwide and Aberdeen New Dawn have gained 37, 32 and 44% respectively over the past six months, but only Aberdeen New Dawn is in positive territory over the 12 months to 1 August 2009.

Our defensive choices generally place more emphasis on the preservation of capital and are more reserved about gearing up. Several use hedging and put options to protect themselves against downside risk. They are safer choices for investors looking for long-term core holdings.
Last year's defensive selections were not as badly mauled in the first half of the period, but they may fall behind in a fast-rising market.

Ruffer Investment Company and Henderson Far East Income were among the top industry performers over 12 months, while our other defensive tips in several categories -- UK mainstream, UK smaller companies, Europe and private equity - were all among the best performers in their sectors over the year.

We prefer to back well-proven managers, particularly if the share price discount to net asset value (NAV) on the trusts they manage pays insufficient regard to their past achievements.
We mostly run our winners and make allowances for trusts that have disappointed in the short term for valid reasons. This means half the trusts selected below have been retained for the second, third or even fourth year. However, we may make a new choice if a previous selection becomes too highly rated and its shares move to a big premium.

We are grateful for the input we have received from various experts.


Defensive: Ruffer Investment Company
The trust has performed exceptionally well over the past year and we retain it as our defensive selection. Manager Steve Russell aims for steady, positive returns, regardless of stockmarket conditions. He was so cautious last autumn that more than half of the portfolio was in sovereign debt, and rotating this between currencies greatly enhanced returns.
Performance also benefited from raising equity exposure in the wake of the October 2008 sell-off. However, the portfolio still has around 40% in a mix of UK and overseas index-linked bonds, plus cash and gold.
Russell says: "The credit bubble has to deflate and, while this is being reflected initially as a deflationary force, we remain convinced that the economic pressures will push authorities into actions that allow inflation and negative real interest rates to dissipate the debt burden."

The equity portfolio is widely diversified, but with an emphasis on the UK and Japan. In the latter, the emphasis has switched from financials to real estate, where Russell hopes for a strong uplift in valuations as well as a good yield.

Aggressive: Edinburgh Worldwide

Its concentrated and geographically unconstrained portfolio has made Edinburgh Worldwide more volatile than its peers over the past year. But it has usefully outperformed its benchmark since management group Baillie Gifford took charge in 2004 and the discount is currently steep for its sector, so it keeps its place.

Manager Mark Urquhart's 30%-plus weighting in the Asia Pacific region and emerging markets, with nothing in the UK, reflects his view that the knock-on effects of the banking crisis will accelerate economic redistribution from west to east.


Defensive: Fidelity Special Values

The discount on our new defensive choice looks surprisingly high, given its long-term record.
Manager Sanjeev Shah has proved a worthy successor to Anthony Bolton over the past 18 months. He shares his contrarian style and penchant for medium to smaller companies, which currently account for half the portfolio.

The trust is around 8% geared, which has worked well recently, but Shah has demonstrated his willingness to use derivatives to protect returns.

"I am currently optimistic about the UK stockmarket," Shah says. "There are financial risks that have not come out yet, and the government and consumers are very indebted. But a lot of this is in the market's price and the policy action has been unprecedented."

Aggressive: Schroder UK Growth Fund
Double-digit gearing proved a big problem for Schroder UK Growth Fund last autumn, as did its exposure to financials and mining. However, manager Richard Buxton reaffirmed his credentials with an exceptional gain over the past six months.
The portfolio is concentrated on Buxton's 30-odd best ideas. He bravely raised the trust's exposure to financials, miners and retailers early this year. He achieved good gains, banked some profits and recycled the proceeds into more defensive businesses such as Unilever and Tesco.
But the portfolio remains biased towards cyclical shares, as Buxton believes his holdings remain "extremely attractively valued on a medium-term, recovered-earnings basis".

"Further recovery by the stockmarket looks possible, but any major upside will be dependent on the economic situation improving significantly, rather than simply looking 'less bad'," he declares.

Happily, he thinks downside pressures are limited by the volume of cash waiting to be invested, so the portfolio is 11% geared in anticipation of strong share price rises over the next year to 18 months.


Defensive: Standard Life UK smaller companies

The trust, also last year's defensive choice, achieved one of the most resilient performances in its sector over the year, despite a dull period in the spring.
Manager Harry Nimmo says: "The trust tends to underperform in the early stages of recovery because of its focus on quality, growth and momentum, whereas the stocks that lead the way early on are the most risky."

He admits that while he predicted a "once in a generation chance to invest in smaller companies" in February, he was late to call the turn. However, he started to gear up in April and expects to raise the trust's gearing before long. "We feel valuations are not stressed and recovery is on track," he says.
Nimmo gives a lot of the credit for his long-term success to the group's proprietary stock matrix, which seeks out improving situations that are not yet fully recognised by the market. It was behind his significant exposure to online businesses such as ASOS and Playtech, which means the trust's exposure to shares listed on the Alternative Investment Market (AIM) is now 25%.

More recently, the matrix has highlighted opportunities among retailers, financials and real estate companies.
The takeover of Gartmore Smaller Companies Trust was a distraction for Nimmo earlier in 2009, but it is now fully integrated. The introduction of half-yearly share tenders from February 2010 should usefully reduce the trust's discount.

Aggressive: BlackRock Smaller Companies

The trust remains our aggressive choice, helped by its wide discount to NAV. Its above-average gearing knocked nearly 5% off its performance in the first half of the year, but accelerated returns in the second, and it will remain positive if smaller companies continue to recover.

BlackRock did well to invest in cyclical shares such as Persimmon and William Hill early in 2009.
Manager Mike Prentis says only half of the trust's holdings derive their sales from the UK. The balance is evenly split between north America, western Europe, Asia Pacific and other emerging markets. He adds that smaller company valuations are compelling, but cautions that investors should maintain a medium-term view of prospects.


Defensive: SR Europe
This trust, run by Sloane Robinson, keeps its place because of its resilient NAV performance over the past year, its excellent five-year returns and its above-average discount.
SR Europe focuses on generating absolute returns, and manager Rupert Dyson has no hesitation in radically adjusting the balance between equities, cash, corporate bonds and short-term debt, as well as hedging the equity and currency exposure.

Only 25% of the portfolio was in equities at the end of 2008, but Dyson reinvested rapidly to get a decent lift from the spring rally.
We like Dyson's long-term bias to mid-market shares and, given that this is a defensive choice, we are comfortable with the emphasis on defensive shares with decent dividend yields that he is finding among telecoms, healthcare firms and large oil companies.

Dyson says he expects macro-economic issues to resurface later in the summer when it becomes clear whether the recent recovery is sustainable.

Aggressive: Charter European Trust

Charter European, run by Allianz Global Investors (RCM), tops its sector over the three years since Mark Lovett was mandated to concentrate the portfolio down to his 30 best ideas. His mid-winter decision to cut back on defensives in favour of unloved cyclical shares helped secure above-average performance in the past six months.
Lovett warns that debt deleveraging will make any upturn "more muted than is traditional after a period of economic contraction". However, the trust's highly selective approach means he can focus on high-quality investments and ignore "broad areas of the European index that appear destined to see slower growth and inferior returns".
In mid-cap shares, for instance, satellite companies SES Group and Eutelsat tick all his boxes by combining highly visible business models and earnings streams, excellent growth opportunities and good quality management.


Defensive: Schroder Japan Growth
This trust weathered the last three years of Tokyo's bear market better than its rivals, yet trades on an equally wide discount. It remains our cautious selection.
Andrew Rose, who took charge 18 months ago, has achieved top quartile results for the Schroder Tokyo open-ended fund over the past five years, and the trust shares the fund's emphasis on larger companies with proven track records. However, Rose spices up the trust's performance by being at least 10% geared and investing more in smaller companies.
Rose hopes that Japan's 20-year bear market finally bottomed out at the end of last year. He suspected the rally had gone a little far by early May, so trimmed the trust's gearing to 10%. However, he remains hopeful on a 12-month view as long as a continuing recovery in China and other parts of Asia helps drag Japan's exporters out of the mire.

Aggressive: JPMorgan Fleming Japanese Smaller Companies

It has had a dreadful three years, but the board of this trust is giving Tokyo-based manager David Mitchinson the benefit of the doubt. So are we, by making it our new aggressive choice.
Mitchinson did exceptionally well in the 2003-05 rally in Japan, first at Framlington, then at JPMorgan. He attributes his subsequent difficulties to a major derating of small, but profitable, well-managed growth companies. While such shares are often favoured by foreign institutional investors, they were hardest hit when foreigners fled the Japanese market.
"These growth businesses normally trade at a premium to the rest of the market, but as a result of this exceptionally aggressive derating process, they now stand at a discount of 50%," he says.

"This reflects an extreme divergence from the average, and is the first time in 45 years that a very substantial discount for future growth has existed. These stocks are not just cheap, but generationally cheap."

Mitchinson does not expect a rapid recovery in the Japanese economy, but he has been encouraged by reports from individual companies that conditions are improving. To demonstrate his confidence, he has cut back on his more defensive holdings and raised the trust's gearing to 20%.

"The smaller company market currently offers outstanding value for investors, based on extremely low price-to-book and price/earnings ratios."


Defensive: Edinburgh Dragon

Aberdeen New Dawn was our aggressive choice last year because we expected its value-oriented approach to do well in difficult markets, whereas Henderson Far East Income was our defensive choice because it looked under-rated relative to its performance.
The latter choice worked out particularly well, but the trust's shares are now on a premium rating. We are therefore reversing the management groups' roles and making Henderson TR Pacific our aggressive choice and Aberdeen-managed Edinburgh Dragon our defensive choice.

Peter Hames, who manages Edinburgh Dragon, is much more cautious about the outlook in general and about China in particular - accessing exposure mainly through Hong Kong because of concerns over transparency and potential government intervention.
The trust is managed with Aberdeen's usual emphasis on a limited range of well-managed companies with robust business models and sound finances, which should survive current difficulties. It excludes Australia and Japan, is focused mainly on domestic sectors and is currently ungeared. It has among the best three and five-year returns in its sector.

Aggressive: Henderson TR Pacific

Andrew Beal has managed Henderson TR Pacific since 2004 and his growth-oriented approach has worked best in bull markets. The trust stormed ahead in the spring and, while Beal was prepared for a summer correction, he expects further strong returns from Asia thereafter. The trust is therefore 6% geared.

The reasons for Beal's optimism range from the massive fiscal stimulus with which the region is seeking to offset the fall in exports, to its youthful population, growing urbanisation and significant increases in productivity.

"We have seen a 40% drop in earnings since the peak in 2007, but expect a very sharp recovery over the next few quarters, driven by greater efficiency, cost-cutting through the recession and an improvement in the top line as domestic economies in the region start to fire," he says.
With nearly half the portfolio invested in China and Hong Kong, and half in financials (including companies involved in residential development), this is not a trust for the faint-hearted.


Defensive: JPM Emerging Markets
This is our new defensive choice, because manager Austin Forey is usually at his best in calmer markets. He likes quality growth companies associated with domestic consumption, tends to be wary of cyclicals - including commodity and energy-related companies - and has been comparatively cautious about prospects for China and Taiwan.

This combination dampened the trust's performance earlier this year, but could work well if emerging markets make slower progress over the next year.
JPM's worldwide team of analysts help Forey drill down to the best 75 prospects in the emerging world. He likes to buy shares on a five-year view and his biggest weightings have recently been in Brazil, South Africa and India. Gearing is minimal.
Forey expects emerging markets to recover from the economic downturn sooner than developed markets and to enjoy a brighter long-term future. He says valuations have risen strongly since the start of the year, but remain attractive and at a discount compared with those in developed markets.
"Volatility will remain a feature of this asset class," he warns. "We believe that, over the coming months, performance will shift towards domestic demand, boosting infrastructure and consumer stocks, as well as financials.

We also expect markets to increasingly focus on quality - rewarding companies that can grow their earnings in a sustainable fashion and build market share in an environment of slower growth."

Aggressive: BlackRock Latin American

The trust's NAV per share plummeted in the autumn, but recovered by more than 50% in the past six months, and six-monthly share tenders keep the discount to NAV tight. The shares have achieved a 57% total return since we selected them three years ago.

Brazil accounts for three quarters of the portfolio. Manager Will Landers is upbeat: "The domestic growth story remains intact and the fact that Brazil is enjoying historic low interest rates, with room for them to fall further, strengthens our positive view of the Brazilian equity market."


Defensive: Electra Private Equity

Shares in our new defensive choice have almost doubled from their nadir, but are still at a discount of more than 30%. Around three quarters of the trust's net assets are invested, its commitments over the next five years total less than £100 million and, having refinanced most of a bank facility which was due to expire in 2010, it has plenty of firepower.
Unquoted investments account for 70% of the portfolio, quoted investments account for 15% and the balance is in net liquid assets of £87 million. The unquoteds were marked down 26% in the half year to the end of March, but by only 15% after currency adjustments, as around half are in Europe, Asia or the US.

This international spread should be helpful, as should the manager's emphasis on protecting and helping its existing holdings.
Electra picked up some temptingly priced investments over the winter, and has been keeping a close eye on opportunities in the small to mid-market sector.

Aggressive: F&C Private Equity

Last year's aggressive selection suffered a harrowing year, as worries about its high level of forward commitments sent this private equity fund of funds to an 80% discount. The share price has recovered by 64% over the past six months, but the discount is still more than 50% to a conservatively calculated NAV, and that is why we are retaining it.

We think manager Hamish Mair will avoid a funding crisis, as the recent sale of the trust's holding in Viking Moorings has reduced the trust's net debt to 11% of assets, and forward commitments have also been whittled away.
The see-through portfolio offers exposure to more than 500 companies, mostly in the mid-cap sector, and Mair has built up the European exposure to around 46%, against 39% in the UK and 7% in US. The trust's fully invested status enhances scope for appreciation if the markets stay positive.


Defensive: Absolute Return

Funds of hedge funds suffered an unprecedentedly poor year in 2008. This has reduced competition for the survivors, who have been back in reasonable form since the year end. If stockmarkets remain buoyant, they will continue to look dull.

But if markets have a difficult year, the funds of hedge funds could regain some appeal, as their spread of disciplines should help them make money somewhere.
Absolute Return Trust, for example, invests in funds specialising in 10 disciplines. The manager, Fauchier Partners, has a good record and makes preservation of capital a high priority. It looks for underlying hedge funds with an enduring competitive edge in their specific field.

The trust's NAV per share fell less than most in 2008, and a halving in the discount has helped the shares gain more than 20% since early 2009, when we suggested a switch from last year's choice: Invesco Perpetual Select Hedge.

The latter has the same manager, but is less conservatively managed and was on a much more demanding rating. It has subsequently slipped back, so those who switched have done well.

Aggressive: Aberforth Geared Capital & Income

The capital shares of this split-capital trust are intensely sensitive to changes in the value of the trust's UK smaller companies portfolio. They were last year's aggressive specialist choice, because we hoped that smaller companies were nearing the end of their bear phase.

This hope proved painfully premature. However, anyone who bought them at close to 100p in the first two months of 2009 has been richly rewarded, with the share price gaining 84%, as the recovery in smaller companies meant the gearing worked positively again.

The capital shares remain our aggressive choice, on the grounds that any growth in the portfolio over the next year will result in much greater gains for the capital shares thanks to their 343% gearing. But be warned, the downside potential is even more dramatic.

This article was originally published in Money Observer - Moneywise's sister publication - in September 2009

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