The integration of the Scottish Nationalist Party (SNP) into parliament could pose a major risk to UK markets, according to FE Alpha Manager Mark Barnett, who released his Edinburgh Investment Trust’s annual report today. 
While voicing other concerns surrounding high valuation, low earnings growth and the impending EU referendum, the report also drilled deeper into the trust’s recent success, attributing this to its weighting in financials, tobacco and in individual stocks such as AstraZeneca and BAE Systems.
Nevertheless, the major focus was on the uncertain environment UK investors now have to deal with.
Though his closed-ended fund has performed well since he took charge of the portfolio from fellow FE Alpha Manager Neil Woodford in January last year, he says he will continue to focus on high quality companies given that the recent election result has thrown up a number of potential headwinds.
“The unexpected outright Conservative victory in the general election was positive for business and for UK plc. Importantly, it removes the uncertainty that would have surrounded a hung parliament and fears of anti-business legislation,” Barnett (pictured) said.
“However, as a result of this outcome two new political risks have risen to prominence. First, the risk surrounding the successful integration of the Scottish Nationalist Party (SNP) into the UK parliamentary system and second, the longer term risk relating to the EU ‘in-out’ referendum in 2017.”
He added: “The latter will certainly have an impact on financial markets and the domestic economy in due course.”
While the election result led to a snap rally in certain areas of the UK market, notably in the more domestically orientated small and mid-cap indices, he says it is more important than ever to prioritise companies which will continue to deliver no-matter what the economic environment looks like.
Performance of indices over 1month
Source: FE Analytics
“Notwithstanding the challenging backdrop, the portfolio remains well positioned to prosper in this environment of continued low interest rates and low nominal GDP growth. Identifying companies that can cope with this environment and where the ability to fund a sustainable and growing dividend remains a key principle of corporate strategy is central to the portfolio’s approach.”
“The portfolio is well represented with businesses with these qualities which should, over the long term, provide the shareholders of the company with a healthy total return from a combination of capital and income growth.”
The Edinburgh Investment Trust has performed since Barnett has been at the helm as though it has only been a short period of time; the closed-ended fund has returned 25.14 per cent, outperforming its benchmark by 11.85 percentage points and its sector average by 14.42 per cent.
Performance of fund vs sector and benchmark since management tenure
Source: FE Analytics
The result seems even more impressive given that Barnett had big shoes to fill following the departure of star manager and FE Alpha Manager “Hall of Famer” Neil Woodford, who announced his resignation from Invesco Perpetual in 2013.
While funds and trusts can struggle following a change in management, particularly when such a highly-acclaimed manager leaves, Edinburgh Investment Trust’s latest report details its “excellent performance” over the year.
“The portfolio’s continued rise in value over a period which saw several high profile profit warnings and pronounced swings in sentiment is encouraging,” Barnett said.
“The market has been driven by a more positive view of those companies able to deliver sustainable growth in earnings, cash-flow and, particularly, dividends.”
The manager accredited a significant amount of the trust’s success to its holdings in the tobacco companies Reynolds American, Altria Group and Imperial Tobacco, due to their strong profit margins and impressive dividend growth.
Over the 12 months in question, Reynolds American delivered returns of 51 per cent and Imperial tobacco delivered returns of 32 per cent. The strongest performer was Altria Group, which returned 58 per cent.
“At the company level, Reynolds American’s agreed acquisition of North American competitor Lorillard announced last summer, should further strengthen its position in the US market,” Barnett said.
“Imperial Tobacco also stands to benefit from the deal, which is currently awaiting approval from the US Federal Trade Commission, as it will make a strategic purchase of some of Lorillard’s North American brands.”
“Within the global tobacco industry, there remain high barriers to entry for new competitors and the existing premium brands strategy continues to demonstrate revenue growth despite a more difficult operating environment in many parts of the world.
“All three companies held in the portfolio continue to offer above average dividend yields, in spite of the strong share price performance over the last 12 months.”
Barnett also says that the portfolio’s exposure to financials including insurance companies, specialist lenders and property companies was a key factor in the Edinburgh Investment Trust’s performance. However, the trust retained its stance on banks, having no exposure to them whatsoever.
Moving away from sectors, the standout individual companies that Barnett praised are BAE Systems and AstraZeneca which, according to FE Analytics, make up 4.3 and 4.6 per cent of the portfolio respectively.
“BAE Systems reported in February that defence spending remained a high priority in a number of international markets and commented that in spite of continuing pressure on public spending in the UK, the company benefited from having long-term contracts in place,” the FE Alpha Manager explained.
“The company also highlighted that its large order backlog of £40.5bn continued to provide ‘good, multi-year visibility across many of their businesses’. The value inherent in AstraZeneca’s drug pipeline was highlighted in April 2014 when Pfizer made a bid for the company, which was subsequently rejected by the AstraZeneca board.”
“The company has continued to make progress and, at the time of the company’s full year results in February, the chief executive described 2014 as having been a ‘remarkable’ year during which six product approvals were announced and the drugs pipeline was accelerated across all main therapy areas.”
On a more sombre note, Barnett listed Drax, Rolls-Royce and Serco as stocks that held the trust back from achieving even higher total returns.
Performance of stocks versus index over 1yr
Source: FE Analytics
He attributes Drax’s underperformance to the plummeting oil price, which was also felt through his other holdings in UK power generators as earnings forecasts were downgraded. Barnett adds that the UK government’s decision to change its method of subsidy for future biomass conversions also bruised the company’s success.
In terms of Rolls-Royce’s disappointing performance, the company issued a profit warning for the second year consecutively, saying that sales would fall in 2014 and could drop again in 2015 for a number of reasons, including the Russian sanctions which blocked diesel-engine exports to Russia.
“It was widely felt that the company could have communicated this news to the market more effectively and action has subsequently been taken by the company to address this issue,” Barnett added.
Serco, meanwhile, suffered provisions and impairments being made due to a management change and several profit warnings.
Despite the Edinburgh Investment Trust’s strong recent performance, its shares are currently trading on a 3.9 per cent discount to NAV. It has, in fact, on average traded on a premium over the last three years, according to the AIC.
That recent discount widening is highlighted in the graph below.
Trust’s discount/premium over 5yrs
Source: FE Analytics
The trust, which yields 3.4 per cent, has increased its dividend in each of the last 15 years. It is geared at 9 per cent and has ongoing charges of 0.68 per cent, excluding a performance fee.