Capital Gearing Trust p.l.c (CGT) Earnings Call Transcript & Summary

Good Morning, everybody, and thank you very much, for joining the Q2 Performance Webinar. I'm afraid, as ever, I shall start with some disclaimers. So the prices of investments can go down as well as up. Should you invest in some of our funds, you may not get back all of the money that you invested. You need to decide whether or not our funds are right for you and/or you should take financial advice in helping you reach that decision. Nothing that Emma and I say in this should be construed as a recommendation to buy or sell security or as a financial advice. Right. Let's get cracking. I'm going to talk about positioning and returns. Emma is going to talk a little bit about the outlook. And then hopefully, we have plenty of time at the end for Q&A. So feel free to start posting those into the chat box, if you wish, or wait until the end and hopefully, we'll have lots of time to answer your questions. Right, big picture, asset allocation at the end of June. Over the quarter, our dry powder fell from 25% to 19%. Our holdings and index-linked bonds rose from 44% to 46%, and our risk assets rose from 30% to 35%. However, some of them move a slightly less dramatic than you might think. So first of all, if we include in our -- if we reclassify our short-dated U.K. index-linked maturing this month, and in March 2026 as dry powder, which might be more proper, then the dry powder rises up to 28%, and the index-linked falls to 36%. And since the end of the quarter, we have continued to trim our holdings in index-linked bonds. And much of that has been reallocated into dry powder. And similarly, we're taking some profits in some of our risk assets. So I think that you should very much think that the portfolio is roughly equally spread, 1/3 dry powder, 1/3 index-linked bonds, 1/3 risk assets. So taking each of those categories in turn, what we've been doing over the last quarter, well, within the dry powder, we've been reducing our weighting to credit, and that's essentially on the back of very good performance, which in turn has been driven by time and spreads. And so we just see that has much less value on up there. We've also introduced a new investment into the dry powder. We are -- in addition to buying sterling treasury bills, we are buying Japanese treasury bills and then hedging the proceeds back to sterling. And the aggregate effect of the yield on the treasury bills and the currency swap just delivers slightly better returns than U.K. treasury bills. And so that's something at the margin we're doing a little bit of. The risk assets, essentially, we've been adding to risk assets on the back of seeing very attractive opportunities in the investment trust market, and that's something I'll come on to a bit later. But at a high level, equities have risen from 16.5% to 18.6%, infrastructure has risen from 6.4% to 8.2%, and then the sort of other has -- which includes property and some kind of high-yield junkier credit, those sorts of things, that's risen from 6.7% to 7.2%. So turning to the index-linked part of the portfolio. We have been selling U.K. index-linked, and we have been buying U.S. TIPS. And we haven't quite finished where we aim to get to. But I think that probably we will end up at roughly 20% in U.S. TIPS, 10% in U.K. linkers and 3% other jurisdictions, that is sort of the shape. Why are we doing this? Well, U.K. linkers have performed fantastically for us. And so in some senses, they're just a victim of their own success. And as things stand today, they look much less attractive than comparable U.S. TIPS. So just taking, say, a 2028 bond by way of example, the nominal -- the return on -- the yield to maturity on a nominal bond in the U.S. is 4.3%. That plays 4% in the U.K. And of course, in some senses, that is the best guess of the nominal return that we will earn from an inflation-linked bond over the period. So that -- what's driving that? So the breakevens in the U.S. are 2.2%, and that contrasts pretty markedly with the breakevens in the U.K. which are 3.75%. Now as you know, U.K., you get paid on RPI inflation, and RPI is structurally higher than CPI and that explains some of the difference. But it's very hard to feel excited about U.K. breakevens at 3.75%. And in turn, that then means that the real yields on U.K. index-linked of that sort of duration are quite low. There are 25 bps perhaps if you adjust for the RPI/CPI difference, that might equate to a 1% real yield, where you're getting a 2.1% real yield in the U.S. And so that's why we're very much with taking profits on our U.K. index-linked, which have been fantastic investments for us, which we largely added about a year ago, actually, was when we were investing quite heavily in them and moving on to higher returning pastures, we hope. Just kind of touching on our views on the TIPS market. The part of the TIPS market that we find most attractive and where we are adding is the 2-year part of the curve. Why is that? Well, it's pretty clear that the Fed has set a very, very high bar for raising rates further. And obviously, the market has now wrote back quite a long way on its expectation of rate cuts in the near future. Although, nevertheless, there are cuts priced in. And it's clear to us that the Fed at the margin is keen to cut rates. And so that probably means that if anything, we would expect nominal yields to be falling a little bit. But crucially, the thing that would prevent the Fed from cutting rates and means that the path of rate cuts is slower than the market presently believes would be if inflation reaccelerates in the U.S. And so under those scenarios, while it's possible that nominal yields might rise at the front end of the curve from here, it seems to us highly unlikely that real yields will rise from here. And that's why we're -- we think that there's a very attractive asymmetric payoff in 2-year TIPS at present. Of course, the downside is because they're relatively short duration, and you don't get a great deal of bang for your buck. But nevertheless, we think they are a good place to park money. We're doing that partly by selling out of U.K. short-dated index-linked and into those tier TIPS, we're also doing it by -- and selling some of our 20-year U.S. TIPS, and putting some of the proceeds in the 30-year, and some in the 2-year, and we think that, that's an attractive place to be. Just turning to performance, you can see that the NAV total return over the last 12 months is 5.2%, which is somewhat ahead of inflation. It's a reasonably satisfactory outcome. We definitely feel that we probably could have done better, but we're reasonably pleased and then you can see the contributions by asset class below, I guess that the one standout performer in that was corporate credit, which returns -- and that's the contribution of 1.1%. The actual return on our credit portfolio was just shy of 10%, which is very close to our risk assets. And that's pretty pleasing given that that's essentially an investment-grade portfolio and short duration. So to deliver those kind of returns was pretty pleasing. I guess probably the one black spot on our performance over the past 12 months has been our exposure to the Japanese yen, which has depreciated roughly 10% over the period. And that's been a bit of a drag. We continue to think that the yen remains attractively priced. We also think there's a reasonable chance that it would perform well in a risk-off environment. So we're maintaining our weighting to the end, understanding the fact that it's been somewhat painful. That's enough on performance and positioning. Here's just the chart of the performance broken out by risk assets and bonds over the longer term. I won't talk to this. But instead, I'm going to spend some time talking about why our risk assets have gone up and what are the opportunities that we're seeing in the investment trust market and where are we excited by them. And I think that there's a few kind of high-level points to make before I come in to some of these investments in detail. The first is that whereas there was a wide market sell-off in particularly in sterling-denominated assets around the kind of trust quanting debacle. And since then, a lot of assets, starting credit, index-linked bonds have repriced. But the one area that hasn't repriced is investment trust discount. So investment trust discounts are as wide today as they were then, and are essentially as wide as they've been since the GFC, that's the first thing. The second thing is that we are able at the moment to invest in some of the largest most liquid investment trusts run by managers that we think are highly competent, where there are Boards that we believe are doing the right thing. And so that's really quite a rare combination, which is very, very appealing. So let's dive into a few of them. So here are 2 large-scale equity investment trusts, Smithson, which is part of the Terry Smith stable, which invests in a global portfolio of mid-caps, predominantly in the U.S. Since inception, since trust has launched in 2018, it's outperformed its benchmark by about 50 basis points per annum. It's trading on a little over about an 11% discount today, and the Board had bought back GBP 200 million worth of stock over the past 12 months, and we have confidence that the Board's intention is to get that discount to the low single-digits. Finsbury Growth & Income needs no introduction. That's run by Nick Train of Lindsell Train, the performance has been absolutely fantastic, since he took over the trust in December 2000, delivered a return of 640% NAV total return versus these comparator index in the U.K. index of 243% over the same period. They promised a discount of 5%, and the trust has bought back 10% of its outstanding shares in the year-to-date so far. RIT Capital Partners is obviously a multi-asset trust previously run by Jacob Rothschild that since its IPO in 1988 has delivered a return of 35x your money compared with 12x your money if you invested in the MSCI World. That's trading on a kind of high 20s discount at the moment. And the reason for that is that there are concerns over the valuations of some of the private companies. However, you can pretty much put a pencil through the whole private equity portfolio and zero that out, and it would be trading at par, and so in round numbers, you get the entire private equity portfolio for free. So that feels like a fairly good place to be. BH Macro, this is a feeder firm for the Brevan Howard master fund and has had a fantastic performance since it IPO-ed in 2007. It's compounded at 8.4% per annum NAV total return. And I mean, that is in and of itself a very attractive return. The other thing to say is that those returns tend to come during risk-off periods. And so as it happens, we very often find that we share macroeconomic views with Brevan Howard. Of course, being a hedge fund, they go about expressing it very differently to us. But -- so in particular, at the moment, that portfolio is very long volatility. They say that volatility is suppressed. It's very cheap and this is not just equity volatility, but also currency and rates. And with everything that is going on in the world, we think that it seems that it ought to be a more volatile environment. And so owning volatility when it is cheap, and which then provides good portfolio protection is appealing to us. And then the other thing to say is that the discounts on this is highly, highly procyclical. So you find that when the NAV performance of BH Macro perks up. And to be clear, it's been very lackluster over the last year or so. But when the performance picks up, then the discount tends to narrow in very, very suddenly. So that feels like a good defensive asset in the portfolio. And then finally, we've been adding, as I said at the outset, to infrastructure, we've been adding to a wide range of infrastructure and it now makes up 8% of the portfolio, split roughly equally between conventional infrastructure 4% and renewable infrastructure about 4%. And you can see here are 2 examples, INPP and HICL, these both trade at roughly 20% discount to their underlying NAVs of course, when a fund holds private assets that gives pause the thoughts as to whether those NAVs are hard. We think the answer to whether or not the NAVs are hard is, probably. And why do we say that? Well, INPP has sold about GBP 200 million worth of assets over the past 12 months at or above book, HICL has sold GBP 500 million of assets at or above book, the most recent disposal was a toll road in the U.S., Northwest Parkway, which they sold at a greater than 30% premium to book, I think. We think that the prospective returns from these assets, assuming no narrowing of the discounts, are between about 9% and 10% per annum. And we think that's something that we can say with a fairly high level of certainty given the fact that the cash flows associated with infrastructure tend to be pretty well known and pretty low risk. So that's kind of a quick canter through the risk assets that we've been deploying money into. Here's the sort of the kind of how the portfolio looks in terms of sort of stretched out by its duration. At the front end, we've got short nominal bonds, which are yielding over 5%. And so that's a great starting place for any portfolio. We've then got the U.K. linker portfolio. But as we've discussed, we're sort of reducing that moving either into the short nominal bonds or into the U.S. TIPS. And TIPS are offering real yields in excess of 2%, which is very attractive. And then finally, we've got our risk assets and there we're enjoying high discounts in the investment trust market. That is enough from me. I'm going to hand over to Emma for outlook. Emma, do you want to take control of the slides? Or do you want me to drive the slides for you?

I'll take control, if you like.

Yes, absolutely. And I take it back when we come to Q&A because in that way, I can pose the questions and pass the difficult ones over to you.

Good morning, everyone, and thank you, Chris. So unusually for us, I'm just looking back and the last time that we spoke to you formally at one of these webinars about the U.S. economy was actually in Q4 2023. So a quick recap on this because basically, at that time, what we were speaking about was that despite the fact that there had been prolonged-type monetary policy in the U.S. and elevated real interest rates, the U.S. economy's performance remains strong and inflation is still abundant. So sitting behind this was a more macro issue for the U.S. economy, which was that despite the fact that actual output -- that actual output was running at levels higher than potential output at full employment, which was giving a positive output gap, which was creating elevated prolonged inflation. And the U.S. labor market had essentially been case in point for this where we saw unemployment very low, below 4%, and wage growth by the Atlanta Fed Wage Tracker measure running at in excess of 6%. Since then, the outlook has changed. And I've taken words the horse's mouth here, that horse being Jerome Powell, the FOMC Chair, that we are now seeing the U.S. economy coming into better balance. And what he means by that is that the outlook for the U.S. economy is starting to soften. So the left-hand chart shows an updated estimate of the output gap from the New York Federal Reserve, which while positive and, frankly, impossible to estimate with any real precision, is now on a very steady downward trajectory. And we can see several things starting to go on in the macro data that's coming out of the U.S. at the moment. So headline employment has now started to rise quite quickly above 4%, wage growth continues to fall. The savings rate has fallen, which is consistent with the idea that U.S. households are becoming more stretched, particularly in the bottom quartile and have used up pandemic savings, headline CPI continues to fall, although it is now doing so very slowly. Again, to take from the horse's mouth, the last mile is the hardest. And although the FOMC members have stated several times over that they need to see consistent set of data showing that inflation is moving towards 2%, we're now starting to see the beginning of these data showing softness, albeit that coming out very slowly. So all this goes to suggest that, as Chris mentioned earlier, there's a growing expectation in market, and growing sort of set in data coming out that's all in favor of rate cuts before the end of this year. The FOMC in their dot plot has suggested a median expectation of 1% cut. I think the markets at the moment are pricing in 1% to 2%. But on the other hand, we've also spoken to you several times about the unsustainability of the U.S. government debt situation. And we're going to speak about it again. And the reason for this is that it remains important in defining what the shape of the long-term interest rates looks like for the U.S. So Bill Dudley, the former President of the New York Federal Reserve, brought this to global attention again recently in an interview with Bloomberg. And his fundamental point was that, although the CBO's estimates of the U.S. budget asset showed a widening to concerning levels, the reality is likely to be much worse than that. And there are sort of 2 key reasons for this. One is that the growth path under these estimates is increasingly optimistic. Over the next 10 years, there is no forecast for any recession in the U.S. economy, for example. And the other reason is that the path of revenue also looks quite optimistic. And the most obvious thing to point out is that the Trump tax cuts, for example, a forecast by the CBO to roll off next year, which is the natural expiry date despite the fact that even the Biden administration, if they get back into power, has stated that they will continue these tax cuts. So both on account of like lower likely growth and lower likely revenues, the deficit is likely to be much wider than the CBO has publicized. And what we've shown in the chart is an alternative trajectory for the deficit, which is conditioned on the IMF's more pessimistic growth estimates, which looks much worse. And all of that is to say that while the macro data is starting to show softness, which all things equal suggest perhaps interest rate cuts from the FOMC, the outlook for the budget deficit in U.S. government deck suggests that there will continue to be upward pressure on long-term interest rates. So to summarize the previous 2 slides, there's basically the sort of 2 directional uncertainty, there's potential for interest rate cuts in response to consistent softer economic data, but there's also potential for rising interest rates off the back of more elevated government bond supply from fiscal deficit. Against this, although Chris spoke earlier about our NAV of 2-year TIPS, our funds TIPS portfolio overall are long duration. So depending on the fund between sort of 8.5 and 9 years. This is against an index, which has about 7-year duration. And although we have been shortening this duration against a backdrop of higher for longer interest rates, we still prefer to be longer than the index. Now why is this? Well, essentially, there are 2 baskets of reasons for this. The first is that we view our TIPS portfolio as a hedge for a financial crisis situation where risk assets, which for our portfolio is largely U.K. equities performed poorly, part of this is a currency angle, which is just that the dollar gets a bid in a risk-off market, but a good deal of it is around the likelihood for nominal interest rate cuts in this type of scenario. Even if you stand back from that, the second reason to hold long TIPS is more agnostic to the macro outlook. So if we simplify the portfolio and essentially take out inflation expectations, and just look at what is the 1-year total return from holding a 2-year and a 10-year nominal treasury instrument in scenarios where there are equal but opposite shifts to interest rates. What you can see from the chart is that there is this notable asymmetry in payoffs. And that is to say that the gain from falling interest rates is much larger from than the loss in the face of rising interest rates. In particular, that this profile is more pronounced with longer duration. So while the 2-year treasury, which we love, is a defensive instrument while interest rates continue to rise, the gains from falling interest rates are relatively limited. By contrast, the benefit of the 10-year treasury is that in falling interest rate scenario, the capital gain is much larger than the potential losses in a rising interest rate scenario of similar magnitude. So given all of this, the combination of the expected payoffs and also the currency dynamics in directionally uncertain interest rate environment, we continue to view that holding these longer duration TIPS is actually a very valuable portfolio hedge, particularly for a sterling-denominated investor, and it remains a key cornerstone to all of our portfolios.

I can see it on the screen. Any questions, and I will stop sharing I will endeavor to stop sharing. I can't stop sharing, maybe [ Katy ] can do that. Right. Any questions, please put them into the chat box if you have them. No questions so far. Well, I hope that, that means -- I hope that, that means that just that we've satisfied you entirely rather than the fact that the chat function is not working, which is the other possibility. It does say the chat has been turned on for the duration of the meeting. Well, while we're waiting for that to happen. I'm going to -- oh, it is...

It's working.

It is working. Well, in which case, that's...

Given that comprehensive an update.

Yes, absolutely. Well, alternatively, we brought everybody's senses. So while we're waiting, I'm going to talk, Emma, about the sporting achievements of the weekend. And I think that it was 2-1 to New Zealand over the course of the weekend in that obviously, the All Blacks beating them in the morning on Saturday by 1 point, pretty bitter pill to swallow. Then we brought it back 1 all when England's women beats New Zealand's women in the T20. But then Lulu Sun, is that her name, tennis player?

Yes.

Beats Emma Raducanu in tennis. So I guess that is an overall victory for New Zealand.