Company Announcements

The Scottish Investment Trust PLC

Results for the six months to 30 April 2019

·    Share price total return -0.5%

·    NAV total return -0.1%

·    Quarterly dividends of 5.3p per share

·    High conviction, global contrarian investment approach

The Scottish Investment Trust PLC invests internationally and is independently managed. Its objective is to provide investors, over the longer term, with above-average returns through a diversified portfolio of international equities and to achieve dividend growth ahead of UK inflation. Today it announces its results for the six months to 30 April 2019. It is categorised as a global trust by the Association of Investment Companies.

Chairman's Statement

Performance

In the six months to 30 April 2019, the share price total return was -0.5% and the net asset value per share (NAV) total return (with borrowings at market value) was -0.1%.

The Company does not have a formal benchmark but, by way of comparison, the sterling total return of the international MSCI All Country World Index (ACWI) was +7.2% while the UK based MSCI UK All Cap Index total return was +6.0%.

This period proved a less fruitful time for contrarian investors. Our contrarian approach seeks to find an appropriate balance between risk and reward in all our investments, rather than attempt to ride every wave of investment fashion. The Manager believes a prolonged period of excessively cheap money has, once again, encouraged an increasingly reckless attitude to financial risk. This means that insufficient regard is paid to the cyclicality and valuation of earnings from certain companies that are, currently, perceived as immune to the fluctuations of the economic cycle. This enthusiasm is most ardent for 'disruptive' technology companies which the Manager sees as most exposed to share price declines when passions cool. Accordingly, these companies are excluded from our portfolio by choice, despite in many cases their large size, as we see greater opportunity in less fashionable areas of the market.

Given our contrarian approach, and as noted in previous communications, we do not expect the Company's portfolio to match any particular index return over any defined period due to the nature of the portfolio's composition. Our approach aims to achieve above-average returns over the longer term by which we mean at least five years.

Our goal

I have previously discussed our goal to build an attractive and differentiated investment vehicle for the long term investor.

We understand that passive products will form a part of many investors' portfolios, but we believe that an important role remains for a genuinely active and clearly articulated approach. Passive products, by their nature, take no account of future prospects or valuations and we believe that it is a source of reassurance to investors that, in contrast, we have an investment team seeking stocks that are undervalued and have improving prospects. A by-product of consistently applying this approach in search of long term gains is that we inevitably endure some periods when performance compares less favourably.

The contrarian approach has allowed the Company to deliver a step change increase in the regular dividend in recent years and we aim to grow this dividend ahead of UK inflation. The Scottish is one of the highest yielding trusts in its peer group and is recognised as a 'Dividend Hero' by the AIC. The dividend is backed by strong revenue reserves which can help sustain our long track record of dividend increases into the future.

We believe that our contrarian investment philosophy provides a solid and prudent discipline with which to deliver capital appreciation and strong dividend income for our shareholders over the longer term.

The many positive attributes of the Company are increasingly recognised by our investors, and by others within the industry, and it is our aim to build upon the hard work behind this. Being named 'Best Investment Trust' at the Shares Awards during the period was testament to our strong progress.

We want to bring our contrarian message to as many investors as possible. There is now a wealth of interesting and insightful content on the Company's website and shared on social media. Most recently, a 'Learning hub' section was added to the website which aims to provide a valuable source of informative educational content for investors. Pleasingly, we have been nominated in four categories at the forthcoming Investment Marketing and Innovation Awards. I would encourage those of you who have not already done so to follow us on social media, where you can find the most up-to-date news and articles from The Scottish.

Dividend

The Board announces a second quarterly dividend of 5.3p. This is in line with the target to declare three quarterly interim dividends of 5.3p in the year to 31 October 2019 and to recommend a final dividend of at least 5.3p for approval by shareholders at the Annual General Meeting in 2020. The first quarterly dividend payment, in respect of 2019, of 5.3p was made in May 2019. The Board's desire is to continue the long track record of annual dividend increases in accordance with the Company's objective to provide dividend growth ahead of UK inflation over the longer term.

Discount and share buybacks

The Company follows a policy that aims, in normal market conditions, to maintain the discount to NAV (with borrowings at market value) at or below 9%. The average discount over the first half of the year was 8.8%.

During the period, 0.9m shares were purchased for cancellation at an average discount of 9.5% and a cost of £7.5m. In the same period last year 0.9m shares were purchased.

Gearing

Having started the year with gearing of 0%, the level was slightly increased to 2% by the end of the period. It is our expectation that gearing will be deployed for the long term benefit of shareholders at the appropriate time.

Outlook

The tentative steps taken by the US Federal Reserve to normalise monetary policy suffered a partial reversal during the period as a programme of interest rate increases has been put on hold. The change in course was prompted by the combination of a sharp, but short-lived, market decline and a series of characteristically pugilistic tweets from President Trump.

It is clearly no easy matter to unwind this era of cheap money as too many asset prices are now apparently supported by low interest rates. This is unfortunate because high asset prices and low interest rates have brought unintended consequences. The most notable of these is an increasing sense of disillusionment with the economic system among many people, particularly the younger generation.

The economic pendulum appears to have swung too far and the counter-swing is more likely to be prompted by events within the political arena. A new breed of politician has tapped into feelings of economic marginalisation and there is a greater willingness to rip up the rule books and question the current state of capitalism. At a minimum, it seems likely that support for the free-spending politician will continue to grow.

The outlook for the global economy has deteriorated since my last commentary although, as yet, not drastically so. The recent escalation of the dispute between China and the US arguably extends beyond trade and could augur a multi-faceted deterioration in the relationship between these two countries with potentially profound implications for investors. The increased tension between the US and Iran risks a disruption to the oil market and has prompted a potentially damaging split between the US and the EU.

An abundance of commentary exists on Brexit and I would simply add that UK assets appear unloved in an international context and we continue to expect the value of sterling to act as a proxy for the state of negotiations.

Although I have spent the last few paragraphs outlining risks, our portfolio consists of investments which we believe are both undervalued and unreasonably out of favour. The long term merits of our investments give us confidence that our portfolio is well placed for the evolving investment environment.

We continue to concentrate on firmly establishing the Company as a differentiated, cost competitive, and attractive investment vehicle focused on delivering above-average returns and dividend growth over the longer term.

James Will

Chairman

14 June 2019

Manager's Review

When I look back, the final phases of the dotcom bubble of 1999/2000 and, separately, the financial bubble which peaked in 2007/8 were, unquestionably, the most educational periods of my career.

Both periods had very different characteristics from which specific lessons could be drawn. For example, the dotcom era taught that while investors can get very excited about a concept, a good story is not enough when confidence evaporates. Meanwhile the financial crisis demonstrated how superficial 'sustainable' profits could be. In the run up to that crisis, banks were involved in a virtuous circle of highly profitable lending, based on rising asset prices which formed the collateral for further lending, higher asset prices and, in turn, produced more 'sustainable' profit. This process lasted until the cycle turned vicious.

But the wider lessons I drew from these bubbles were not so much the specifics, for these will always be different the next time. Instead, the most interesting lessons were derived from how people behaved and the conclusions they drew as the bubble neared bursting point. It would appear that human nature doesn't change which is perhaps why financial markets have always been plagued by booms and busts.

Almost 20 years ago, the market had an insatiable demand for stocks that would give investors exposure to the internet. Indeed, companies that merely added '.com' to their name would see a positive price reaction. Noticing this, entrepreneurs and stock promoters began to rush new companies for 'beauty parades' with the intention to raise enough cash to justify a flotation.

As the callow junior analyst (this was before my time at The Scottish), I was frequently despatched to meet some of these potential newcomers. In my keenness, I went armed with questions, but it quickly became obvious that questions were neither wanted nor required. These 'internet incubators' did not really have credible plans, the founders became indignant when quizzed and there wasn't really anything of value other than the prospective cash that would be raised. The main selling point was instead the dangled prospect of a substantial return to someone who backed the flotation as the share price was expected to spike higher (or 'pop') on the first day of dealings and would trade on a 'multiple of cash' (a valuation metric a bit like someone offering to value your bank balance at a multiple of what it actually is).

Now, if this sounds crazy, it's because it was. But, shares in these companies sold like hot cakes. No doubt, some investors did believe in the long term merits of these companies but the majority were merely confident that there was somebody behind them willing to pay more. Investors were able to successfully 'flip' several of these new businesses but, when the music stopped, the loss from a single flop more than offset the gains on the winners for many.

The reason I have dredged this anecdote from the depths of my memory is because conditions today make me draw parallels with that time. Today the buzzword is 'disruption', with an enthusiasm for privately held start-up companies valued at more than $1bn - known as 'unicorns' - that will achieve 'profitability at scale.' Perhaps some will, but many unicorns seem to have business models that rely on constant injections of cash which have been facilitated by an easy money environment and a high level of confidence in their long term story.

Recently, there has been a rush to bring some of these companies to market, perhaps because the backers wish to exit while the going is still good. Watching one of the well-known business channels, I was surprised to see the guests discussing not the prospects of a grossly unprofitable business but instead the 'pop' in the share price that the investment bank would engineer on the first day of trading (ominously, the share price instead flopped).

All-in-all, it is hard not to see these unicorn flotations as the apex of a renewed case of unbridled enthusiasm for all things technology. While we have nothing invested directly in this area, the fact that this mentality exists and covers a large part of the market is a cause for concern.

In recent months, President Trump seems to have interpreted market levels as a real-time opinion poll on the competence of his administration. It's easy to see where he is coming from - after all the mantra of President Clinton's original campaign was 'it's the economy, stupid.'

The trouble is that overall market levels generally do not reflect the current fortunes of the economy. Market levels, in fact, better reflect the degree of confidence in the aforementioned 'disruption' bubble.

As we expect this bubble to deflate, we think it is highly likely that President Trump's vociferous campaign for the US Federal Reserve to cut interest rates and print more money will ultimately prove successful.

We expect our gold miners to be one of the principal beneficiaries of this shift in monetary policy. Whereas the value of paper currency is eroded by the unrestrained printing of new money, gold has historically maintained its purchasing power over long periods of time. We also see opportunities for long term investors in many areas overlooked in the current environment.

The portfolio

Markets endured a roller-coaster ride over the interim period. Trade wars, rising US interest rates, a US government shutdown, Brexit, a collapse in Chinese car sales and, perhaps most importantly, fears of a US recession all contributed to a sense of angst that reached a nadir around Christmas. However, concerns dissipated when it became clear that the US Federal Reserve would, if required, take action to support equity prices.

Generally speaking, our more defensive investments provided the best returns, holding up in the market decline, although not all participated in the subsequent market rally. Our more economically sensitive 'ugly ducklings' suffered in the market downturn and, while these recovered in the subsequent rally, the uplift was not as significant as the downdraft. Outwith the technology area, markets seem to be pricing in a greater risk of recession.

One of our best gains over the period came from gold miner, Newcrest Mining (+£5.0m). We recently added to our holdings in this sector, including a new holding in Barrick Gold. In addition to the aforementioned merits of gold, the gold miners are set to reap the benefits of a wave of consolidation. Strong gains also came from BHP (+£5.0m), a diversified miner. A healthier focus on capital discipline has helped the company to deleverage and make significant cash returns to shareholders.

Pharmaceutical companies GlaxoSmithKline (+£2.0m) and Roche (+£1.4m) both rose as confidence in the outlook for drug sales grew. Meanwhile, US health major Pfizer (-£1.7m) lost some of its recent strong gains.

We added several new holdings in the telecoms sector during the period. Our longstanding investments in China Mobile (-£0.4m) and Verizon Communications (-£0.1m) held up amid volatile stockmarkets, while we initiated new holdings in Orange, KPN, Deutsche Telekom, Telstra and Tele2. The regulatory environment appears to be shifting towards a more pragmatic approach, as regulators now wish to encourage investment in the next generation of technologies such as 5G.

The retail sector was a source of mixed fortunes over the last six months. While each investment is different, our central thesis has been that the future of retail looks to be multi channel ('bricks and clicks') as the economics of online only sales are poor (the cost of delivery and returns destroy profits). Our holding in Tesco (+£5.5m) is delivering well on its turnaround plan, while Marks & Spencer (-£0.2m), Macy's (-£7.8m), Target (-£2.1m) and Gap (-£1.4m) have plans which are yet to be fully realised. Macy's was a disappointment as, having nearly doubled last year on an operational improvement, it gave back most of those gains as sentiment soured.

The financial sector generated mixed returns over the period. Strong returns came from Standard Chartered (+£6.0m) which benefited from an improved outlook for the Chinese economy. ING (+£1.7m) and Citigroup (+£1.1m) also gained. Our Japanese banks, Sumitomo Mitsui Financial Group (-£2.2m) and Mitsubishi UFJ Financial Group (-£2.7m) were among those to register declines as, in the absence of near term interest rate increases, banks faced a more difficult task to boost returns.

Energy returns were also mixed. Amid the uncertain economic environment, markets favoured the more defensive oil majors over more cyclical oil equipment and services companies. US oil producers Chevron (+£1.0m) and Hess (+£0.9m) were among those to gain while National Oilwell Varco (-£3.9m), TGS Nopec Geophysical (-£1.7m) and Diamond Offshore Drilling (-£1.6m) lagged.

Elsewhere, solid gains also came from PepsiCo (+£2.3m) which is embarking on a plan to reinvigorate sales growth under a new CEO. UK water and waste services provider United Utilities (+£2.2m) also had a positive six months as regulatory risks eased.

Outlook

The provenance of the expression "never believe anything until it is officially denied" seems to be disputed but it nonetheless shows a great insight into the realities of politics, bureaucracy and perhaps life itself. Denying something, truthfully or not, gives credibility to the matter in question.

So, with this logic in mind, it was somewhat perturbing to see a tweet from the official White House account with the text "We're killing it on the economy!" accompanied by a 30 second video of Larry Kudlow, President Trump's currently most favoured economic advisor, selling the merits of the economy in a manner reminiscent of a TV home shopping infomercial.

Admittedly, Mr Kudlow wasn't denying anything, but it still begged the question as to why the topic was even being discussed. It seemed odd behaviour. Would it not have been better to let the economy do the talking?

Of course, President Trump was elected precisely because he defied convention and perhaps one should not be surprised when members of his administration deploy unorthodox tactics to buoy confidence. However, global growth appears to be slowing and although the stockmarket has cheered what it sees as an apparent peak in US interest rates, the full effect of the previous interest rate increases has yet to be felt.

US and thus global stockmarket indices remain heavily skewed towards the technology, unicorn and new media areas and it is here that we think that valuations and expectations remain overly enthusiastic, creating a suboptimal balance between risk and reward. We have purposefully minimised exposure to these areas. Outwith these areas, valuations remain more reasonable, and our portfolio focusses here.

As I have previously noted, as contrarian investors we actively seek unfashionable and unpopular investments that we believe can recover. This is where we find the best balance between risk (expectations are low) and reward (things can get better). Our investment approach is designed to anticipate and benefit from change and we will continue to seek out opportunities with potential to profit the long term investor.

Alasdair McKinnon

Manager

14 June 2019

For further information, please contact:   0131 225 7781  

Our Approach

To apply our approach, we divide the stocks in which we invest into three categories.

First, we have those that we describe as ugly ducklings - unloved shares that most investors shun. These companies have endured an extended period of poor operating performance and, for the majority, the near-term outlook continues to appear uninspiring. However, we see their out-of-favour status as an opportunity and can foresee the circumstances in which these investments will surprise on the upside.

The second category consists of companies where change is afoot. These companies have also endured a long period of poor operating performance but have recently demonstrated that their prospects have significantly improved. However, other investors continue to overlook this change for historical reasons.

In our third category, more to come, we have investments that are more generally recognised as good businesses with decent prospects. However, we see an opportunity as we believe there is scope for further improvement that is not yet fully recognised.