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

Good morning, and welcome to the CG Asset Management Q3 Investor Presentation. For this recorded meeting, investor's will be in listen-only mode. [Operator Instructions] Before we begin, we'd like to submit the following poll. I'd now like to hand you over to Sophia Sednaoui, Head of Investor Relations. Good morning.

Good morning. Thank you so much, Paul. Welcome, everyone. For those of you who don't know me, I'm Sophia Sednaoui, Head of Investor Relations at CG Asset Management. Very happy to be here today with Alastair Laing and Hassan Raza from the fund management team. First, I'm going to get the admin parted out the way. So please refer to our disclaimer here, essentially investments kind of go up and down. And nothing we say in this webinar should be taken as advice. The team will shortly be giving an update on what's been happening over the quarter as well as key themes and opportunities that they're seeing in the market at the moment. You will see some performance and allocation information from Capital Gearing Trust. It's worth remembering, however, that the team's macro views and allocation decisions are relevant for our entire fund range across both multi-asset and fixed income, as you can see on this slide. I would also -- while I have you, I like to flag that if you'd like to see the team in person, we are actually hosting our Investor Day on the 5th of November. So do reach out if that is of interest. And another couple of dates coming up are the Capital Gearing Trust Interim Results on the 18th of November. And an index-linked bond seminar, we will be hosting in January. And on that note, I will hand over to the team for the update.

Thank you. Good morning, everyone. If I may, I'd like to focus on 3 things: our performance, the largest changes to our holdings over the last quarter and why I think discounts will narrow, both naturally and with some help. Looking at performance. It has, of course, been a quarter where markets have shown how brittle the plumbing is. Investors who had grown accustomed to benign volatility in Japan were carried out when the yen appreciated violently at the start of August, the impact of which reverberated across global equity markets, particularly U.S. growth stocks. Over the last quarter, the yen has appreciated 12%. And as you know, the portfolio has been positioned to benefit from this. The remaining exposure to currency is 9%, but it was also pleasing to see all of our asset classes contribute positively to performance, both over the quarter and over the last 12 months. So where does that leave the portfolio today? Well, the 2 largest changes to the weighting have been a 3% increase in our risk assets and a 10% decrease in index-linked bonds. On risk assets, we took the opportunity to deploy some dry powder to U.K. and Japanese equities around those turbulent weeks of August. We have subsequently taken profits in several positions that have performed well. Now whilst investment trusts remain attractive, 36% could well be the high point in cycle for risk assets. This is because volatility is elevated heading into the U.S. election with significant tail risks. The economic data is not harmonious and global equities remain vulnerable to a correction in the U.S., which is priced with an adequate room for error. For fixed income -- for index-linked bonds, nearly all the weight has come out of the U.K. from the maturing July '24. Proceeds have gone into treasuries, where we see better relative value. There's also been a modest increase in the U.S., where our duration is longer at 8.7 years and we favored TIPS on valuation, currency and portfolio insurance grounds. Looking back longer, and I've taken this data as far back as Bloomberg allows us to disaggregate it. Both are bonds and equities have contributed to performance. In particular, as you can see, the risk assets have widened their outperformance against the investment trust sector over the last quarter. Actually, on the investment trust sector, in particular, I have been asked by many of you this year if the sector is destined to shrink to irrelevance. So the case i put forward is this, the investment trust sector has not just survived, but thrived over the years. Assets in the sector have grown 10% per annum over the last 20 years on average. It has been the fastest growing in market cap and the most dynamic, at least in the number of new companies listing in part of the old share. It has outperformed the U.K. equity market and for most of the last 20 years, global equity markets. In fact, discount expansion explains about 2/3 of the underperformance in the last few years and discounts have, indeed, been wide. In fact, at their widest level since 2008. But should these discounts narrow, and I think they will, in fact, they have already started to. Then there is a strong historical track record for outperformance. I believe these discounts are cyclical and part of the healthy Darwinian rhythm of the sector since 1960 -- Since 1860 in fact. And there are several catalysts at multiple levels to accelerate the cycle. At a macro level, you have the rate cycle turning. We have better balanced allocations to fixed income, multi-asset redemptions have slowed and cost disclosures will help at the margin, I think. At a sector level, we saw rampant issuance over the last few years, creating an oversupply shares with price picking up a slack. But there has been a record return of capital through buybacks and corporate actions, which is accelerating. Last year, we saw 15 mergers. Realizations are windups. Year-to-date, we have seen at least twice that either announced or completed. So the sector is not waiting around and it's pulling its returns up by its bootstraps. Stock-specific level governance has improved over the years. Boards are much more willing to engage, especially with us via stock. We're not seeing as transient activists. We have built enduring relationships with boards over the last half century. One recent example and perhaps a more public engagement than we would like is PRS, one of our largest property holdings who released results today. I should add that whenever possible, we would much rather prefer to do things privately. In this instance, noting the discount, the generously long contract that awarded to the manager and the additional fees from a potentially conflicted third-party adviser, we submitted a requisition notice to call for an AGM to appoint [ Christopher Mills ] and [ Robert Naito ] to the Board. There were constructive conversations, the chair has stepped down and the strategy is being revamped with the new Board, and we've withdrawn on our notes. Shares have rallied 35% over the quarter, and we expect this to improve as PRS moves into the 250. As well as PRS, there has been a notable increase in the number of special situations and merger arbitrage positions this quarter. And we look forward to updating you all on their progress in due course. So to conclude, performance has been resilient, and we are constructive that risk assets will deliver outperformance.

Great. Thank you, Hassan, and good morning, everyone. For those who don't know me, my name is Alastair Laing. I am the Chief Executive of CG and on the investment team alongside Hassan. So today, I'm going to look a little at the outlook. Try and gaze a bit into the future. And as Hassan has made clear in his segment, there's a lot to be optimistic about in terms of investment trust returns, which raises the valid question of why do we have 1/3 of the portfolio in these opportunities, why not whole. And I think part of that relates to our concern about the prospects for the macro environment. There are quite a few warning signals that are flashing red at the moment. And I might just run through a few of those. But I'm going to start off really with a bit of a health warning. I'm going to talk about football and of course, a breakout star of the 2010 World Cup, which was a course called Paul the Psychic Octopus. Who had an extraordinary track record in correctly predicting the outcome of a whole variety of games, including the fact that England would lose, as it turned out 4-1 to Germany, and Spain would go on to win. Paul had the great good judgment after an effective run of predictions to retire. So his psychic reputation was intact. But I mean, this is quite a slightly light-hearted way of bringing up the risks of some of the, kind of, indicators I'm going to look at. I guess maybe if we think something like the Goodhart Law, that it says, "as soon as a measure becomes a target, the measure ceases to be effective." A number of these warning signals that I'm going to point to have some theoretical and other questions that can be raised about them. But it is notable, how many of these are flashing red at the same time. So maybe I'll just jump in, perhaps the best known psychic measure within the financial macro area, and also one whose reputation is somewhat under question at the moment, and that is the inversion of the yield curve. The term inversion of the yield curve describes a situation when long run rates are lower than short run rates. And this is an inversion of the norm theory says that long-term interest rates should be higher than short-term interest rates to recompense investors for having a capital locked up for longer periods of time. And this measure was actually brought prominent in the 1980s by Chicago University's economic school. And they pointed out -- some of their PhD students pointed out that in every recession since the second world war up to that point in the 1980s have been preceded by a yield curve inversion. Now on the Goodhart's Law, we have now identified the measure, and it should start misbehaving. But actually, the measure you can see here from the 1980s onwards continue to be an extremely good indicator of imminent recession and we can maybe talk a little bit as to why that was. However, this measure has taken a bit of a knock recently. You can see on the far right of this chart, sorry, I should mention, but this chart shows the 2/10 spread. That is the yield of the 2-year treasury over the yield of the 10-year treasury. So when this slide goes below 0, it shows an inversion. And you can see that the inversion on the right end of this chart was the longest and deepest inversion that has been seen certainly since the second world war. And a number of economists, forecasters and indeed ourselves we're saying in mid-2022 when this signal came up, we started raising some concern that, historically, this has been signed recession. Of course, over the last 2 years, the U.S. economy has been surprisingly strong. So it may be that this is an example of a signal misbehaving. It may be that the severe disruptions of COVID just created situation where this measure was no longer relevant. The pass-through of inflation may have really thrown this measure out. But there's an interesting recent paper by Jim Reid at Deutsche Bank, that pointed out that the most proximate trigger of recessional slowdown is not, in fact, the inversion. It is the disinversion, i.e., the point at which the 10-year rises back above the 2 year. And this typically occurs because the 2 years start rapidly falling, i.e., it is the steepening of the yield curve after the inversion that is the most proximate trigger. And that's certainly been the case. You can see in these recessions since 1980. It's the point at which this line 2s, 10s line goes back above 0 that the warning signal really starts to flash. And this might just be kind of an egregious case of data mining but maybe we might think a little bit as to the theory behind why that might make sense. So on this chart, we've got the U.S. yield curve today and the U.S. yield curve a year ago, which is above it in the green line, the U.S. yield curve today is in the pink. This look disarmingly like a couple of Paul's tentacles calling out there. I would say the curve a year ago was an almost perfect example of an inverted yield curve other than in the 20-year period, each of these benchmark bonds is lower than the bond preceding it. So why might this kind of setup be a signal of an impending recession? Well, the theory goes, or at least the heuristic goes, that an inverted yield curve tells you that some point out there in the medium term, you are -- the interest rates are going to be coming down potentially quite fast. So that's why you get this distinctive offset. And indeed, as we roll forward to the pink line 12 months later, you can see that the inversion has -- we have disinverted at every point other than the 1-year bond. And given that interest rates have recently dropped and that there 8 interest rate -- forecast interest rate cuts implicit in this curve before the end of next year. Clearly, the bond market is saying that interest rates are coming rattling down, and that will only occur in a period of soft economic growth. So you always have to have a warning sign that there could be, particularly, the kind of very elevated burst of inflation might have thrown this measure out somewhat. But certainly, we can see this measure is suggesting that the economy is weakening and that we are likely to face a number of interest rate cuts over the next 18 months. Federal Reserve itself has pointed to another 2 interest rate cuts for the rest of this year and the market is then pricing in another 4 next year. But it's not just -- if we're thinking of the spooky long-term psychic measures, it's not just the yield curve that is inverted. We also have another of these long run heuristics that has been, if anything, an even better signify recession called the Sahm Rule. This was made prominent by Claudia Sahm, a former Federal Reserve economist, was actually working at Brookings Institute when she wrote about this measure. And this is a relatively simple measure in the green line, we have the rolling 3-month unemployment rate. And her heuristic proposition was that if the rolling 3-month unemployment rate rises by more than 0.5 than over the preceding 12 months, then that is an indicator of actually that you're already in an early stage of recession. And really, the theory underlying this is that unemployment is a somewhat backward-looking measure. So by the time you're all seeing rapid rises in unemployment, the economic situation is already moving quite rapidly. Now I mean, this unemployment is a noisy measure. A number of you would have noted that the last payroll numbers was actually very strong. we'll have to see how it pans out. And also, again, you can say that the unemployment -- sorry, the employment changes around COVID, which is so stark. And in such an unusual context that maybe the unemployment data is likely to be somewhat complicated for a number of years to come. However, it is absolutely -- it is kind of notable that this, which is probably the most reliable indicator along with an inverted yield curve is sending a warning sign that precisely the same time. So yes, just to come back to say these are heuristics are not fundamental laws. I said earlier that Paul had a good sense to retire. He actually died -- and that is obviously the -- from the point of view of the psychic reputation that is the very best thing to do. It may be that all of these rules will be shown not to be -- in this scenario, have quite the kind of forecasting capabilities. But if we look at a whole range of other indicators, it is notable that a lot of them are slowing. So I show here credit card debt, delinquencies on the left, we can also see there's an incredibly low savings rate in the U.S., all of which points really to, I guess, the bottom half of the income scale in the U.S. probably really struggling, I suspect a number of the stimulus checks that aligned post -- during the post-COVID have now been spent. If we look on the corporate side here, you can see the CapEx, expenditure, which kind of forecast in orders which boomed after the Inflation Reduction Act are showing quite a dramatic kind of reduction. We can see manufacturing PMIs and ISMs slowing down as well. And against the backdrop of the U.S. economy running, a kind of 6% current account deficit, i.e., the government is stimulating via a lot of channels such as the Inflation Reduction Act. It is quite surprising to see the synchronized measures of unemployment, capital goods and a number of the kind of savings data softening all at the same time. So I think that is genuine call, there's genuine reason to kind of pause for thought here. The U.S. economy has been the absolute exceptional outlier of China and Europe, in particular, have obviously been struggling over the last couple of years. It's really been the U.S. that has been motoring along, and it's fair to say in here as well but there are reasons to be concerned about whether at least this element of U.S. exceptionalism will continue. But there is one area of U.S. exceptionalism which remains completely intact. And I guess this is the 1/3 of our kind of measures that has been held in high regard by investors historically, although somewhat questioned by a number of investors today, and this is the cyclically adjusted P/E ratio. That is to say the price of stocks based against the trailing 10-year earnings. It's a kind of fundamental measure of valuation that was popularized in March 2000 by Robert Shiller he had been measuring it for a little while in his book, Irrational Exuberance he published in March 2000, where the CAPE hit 42, an all-time high by a long stretch. And that absolutely marked the peak of the dotcom boom and the subsequent unraveling. This measure kind of rose up strongly after -- sorry, it fell down after the global financial crisis rose up strongly again. It peaked in 2021 in the kind of COVID everything bubble. It sold off dramatically, but now at 37%, it's in its 97 percentile, just below those peaks, but essentially a extremely elevated levels. And really, what's been driving this has been a narrative of AI in the Magnificent Seven. They are a very significant portion of what's been driving this upward revaluation of stocks. And you really have that kind of combination, which is quite reminiscent of the late 1990s of very high equity valuations at very least a slowing economy, that very strong tech narrative which, by the way, turned out to be absolutely correct, the Internet and communications revolution has transformed the corporate landscape. It's transformed how we all need our lives. But it just took quite a long way to really impact the economy in a very substantial way. I'm not going to talk extensively about AI, but I would point out that Goldman Sachs recently brought out a paper suggesting that we need about GBP 1 trillion of capital expenditure to roll out over the next few years. A great example of that which is Microsoft really essentially acquired by a 20-year power purchase agree the U.S. -- the mothballed U.S. nuclear plant three-mile island that have -- the U.S. most famous nuclear disaster, but it essentially took this out of it's -- this has been unmothballed, brought back into production in order to feed the extraordinary power needs of AI. And so I would just point out that this is a very different type of foundation myth from, say, Mark Zuckerberg or whoever exemplified Jeff Bezos, the Internet revolution, these guys in their backyard typing away software code which was the ultimate CapEx-light model, these AI revolutions come literally with nuclear power stations attached. It is extraordinary the amount of infrastructure that's required. So all to say, there is a risk that we face unless there's a pretty short-term payoff in these extraordinary levels of capital expenditure. There's a risk that we face over the next decade, a situation a bit like what occurred in the 2000s where you have profitability weighed on by write-downs of significant areas of CapEx, you have equity valuations starting at very high levels and you have a slowing economy, whether or not it goes into a recession may not be even be a central point here. It's just a very potentially difficult setup for investors and in this quick kind of tour of the horizon, I wanted to touch on the bond market, which here we can see global real yields and a number of developed markets. There was clearly a massive repricing that occurred in 2022 but since then, as the treasury yield curve showed that we were looking at earlier, we have typically come off the top of the real yield environment. And as we move into an interest rate reduction cycle we have tended to see in generally real yields come off there, 12-month high and move downwards and some gains in the domestic value of these bonds. As Hassan pointed out, we did in, particularly, the aftermath of 2022 with post the list trust kind of debacle,we moved quite significantly into U.K. index linked but it is now a number of the bonds that we've held, the interest rates have come down. We're beginning to see a quite significant spread as we reappeared between U.S. TIPS and U.K. index linked. So once again, we've got a situation where we are holding -- our largest holding is in U.S. index-linked bonds. And if we look at these values in absolute terms, when you have 10-year real yields, a just shy of 2 real. That's not historically standout good value, but these do look like instruments that are fairly valued in the current environment and indeed seem to have a bit of a tailwind. Now we've moved into a falling interest rate environment. So we think that there's a firmer backdrop for bond markets even if we're not necessarily in the short term, anticipating a move back to negative real yields across the board. So I'll just sum up trying to pull those different threads together into how we have the portfolio's positioned today. And as Sophia pointed out, we're talking here about Capital Gearing Trust that this absolutely runs through the absolute return funds, CGT portfolio fund. We have about 30% of the portfolio in cash short run treasury -- sorry, short run credit, we've actually been selling down some of our credit positions because they performed so well and spreads have come in. But still, that overall portfolio is delivering us just shy 5%. It's very high-quality credit returns. We think regardless of the environment whether we're going into a recession or not, that is a sensible place to hold a portion of the portfolio so that we can respond to better values. Should they emerge in either the bond or equity markets. Then we retain a bit of duration in the medium term through U.K. index link to over longer bonds in U.S. index-linked, these are all offering positive real yields, which is fantastic. We're not guessing that we're going to get a return over inflation. We know we're going to get return over inflation. We have a bit of duration here that means if interest rates come down, we feel that we will continue to benefit from that. And then finally, we have just over 1/3 of the portfolio, predominantly invested in a range of investment trust opportunities that we're quite -- we're really quite confident now we're going to outperform. For example, global equities over the medium term over the next 5 to 10 years, starting from the kind of valuations that we do today, the kind of discounts that we have today as contrasted to say the Magnificent Seven valuations as the kind of CAPE type valuations that are very elevated to us. But we only have just over 1/3 of the portfolio there because if we are entering a kind of early 2000 situation of weak equity markets, we want to make sure that this portfolio is not going to suffer significant drawdowns. And essentially, when you have 65% of the portfolio that we're confident will be delivering returns in our fixed income positive returns regardless of the environment. That gives quite a lot of cushion such that if our risk assets perform well and we're too bearish on the outlook and equities continue to thrive, we should still be able to deliver mid- to high single-digit returns across the portfolio, and that's absolutely adequate for a very low risk portfolio. But if we are facing tougher times, that engine room of defensive assets should mean that we can continue to grind out positive returns. So that's really how this is set up. And just as a final comment, I've been talking for a little while here, but given I was thinking a little bit about 2000 and 1999 and the kind of tech, the dot-com bubble. I looked back at the Capital Gearing Trust asset allocation from 1999 and there was then about 50% of the portfolio that was in short-dated nominal instruments. We had about 15% of the portfolio in longer-dated predominantly index-linked government bonds and then about 1/3 in index linked -- sorry, in investment trust instruments. So although there was a much a greater weight in those date -- the short-dated nominal instruments were largely 0, and that market is somewhat what disappeared, this is a tried and tested asset allocation, and I just thought it's remarkable and interesting how similar we set up to where we were 25 years ago. So on that note, I will stop, and I will hand over for some Q&A.

I was going to say, Alastair, thank you very much indeed, and Hassan, thank you for updating investors presentation. [Operator Instructions]. Thank you for all the investors for submitting those. If I may just ask you to read out the question where appropriate to do so, and I'll pick up from you at the end.

Brilliant. Thank you so much. So definitely a topic is the investment trust allocation. I'll start with the first question around cost disclosures. So given recent announcements from the regulator, are you encouraging the Boards of the trust you own to update the reporting of their costs to 0? And likewise, are you doing the same Capital Gearing Trust?

I will not comment on the precise detail just because I don't want to get it wrong. But we're absolutely aligned with the general direction of that. We have changed the U.K. kit for Capital Gearing Trust. We're looking at our EU kits because the rules have not changed there. But yes, we are looking at that. We are engaging with other investors and other investee companies on changing the OCFs so there are lots of people taking advice, as you'd expect, with listed companies. This is an important disclosure. We don't want to get wrong. But absolutely, this is the direction of travel. And I think for a number of companies, it will not be kind of game-changing, but there are certain companies, particularly in the alternative space that were under value for money, criteria were being essentially very least flagged up, if not completely withdrawn from a number of retail platforms. So I do think there are cases for some of the really unloved investment trusts and the largest discounts to actually be positively impacted by this. So yes, that's a great for the sector.

I would only add and perhaps not just related to disclosure, but we've been encouraging trusts to not just disclose but lower their costs over time, right? There's -- if you think about it, it's about 370 trusts in the space, 125 of them are under GBP 400 million. they've traded on a double-digit discount for last year, and they charge fees over 1%. So we may not agree with them on buybacks or wind downs or other corporate actions, but we can agree generally that fees are lower fees are constructive to shareholder returns in the interim particularly if there's not been any issuance or development activity. So we are challenging trusts that have had a period of underperformance on their fees frequently.

Great. Thank you, Hassan. I mean this leads quite well into the next question, I guess from David. Thank you very much. With so many listed vehicles trading at significant discounts to underlying value very much like PRS, do you anticipate becoming more active to realize greater value.

I would say we are active and in our preferred manner. The approach to activism more broadly is should be outcomes based, I believe. When I compare the investment trust sector to my previous slide in restructuring and workouts, the stakeholder base is much more diverse. There's a lot of competing interest. So I always come back to yes, you want to be active, but you're going to create noise of what are the outcome will achieve and will those be in a timely manner? And to that, I think an activist approach that's quite noisy that doesn't necessarily yield the outcome you want in a timely matter. It ties up a lot of capital it increases the risk-adjusted return. It will increase the risk side of the equation. So I think you have to think about a more active approach in the context of an outcome-based framework. Where we've done that publicly and historically more successfully is perhaps in the renewable space. We don't need to own a very large majority of the company, but we can influence the narrative and the story by marshaling together the shareholder base on a particular message ahead of a continuation but we can guide the company towards reducing their allocation to riskier asset classes and commit to doing that over a period of time. So I think it's about taking a pragmatic approach and understanding the influence you'll have against the risks that you take when you're looking at this. And essentially, but the guardrails around investments that either enhance returns or reduce risk over a period of time.

Now somewhat more technical question, again, related to Trust selection. How does liquidity impact trust selection? And do we have a lower threshold in market cap? And how big is our target universe?

So I would say that liquidity is certainly a factor, but I would put the question in 2 ways. I think there's a defensive and an offensive element to how you think about liquidity. We are very risk conscious and for us defensively looking at the liquidity of investment trust is core to how we size the position. So the outcome of all of that is that you can liquidate near enough 80% of the portfolio with a 20% participation in less than a day. So our portfolio is quite liquid, which allows us, which not just expresses the defensive nature of how we think about liquidity, but also allows us to be offensive when markets capitulate. So when I think to March this year, when I think to October last year, we were a provider of liquidity. We're able to pick up large block size positions in trust that we have been following competitively and on occasions below the bid. So I think -- when we think about liquidity, it runs for our whole portfolio, and we have a defensive and offensive element to it. Does it limit our universe? Not necessarily because I don't think market cap is necessarily the best way to measure it. I think there is a trading off market. There is a change in many of the structures we're seeing in trust, new tender mechanisms, buyback activity. And so the historical volume, all necessary the market cap doesn't necessarily reflect the prospective liquidity we might be in a trust. So it doesn't limit our universe but we are certainly conscious of it as a defensive and an offensive tool.

Okay. And just to, I guess, frame it a bit, I think, if I'm not wrong, the investment trust universe is about GBP 200 billion of market cap and there are about 350 trusts that we can invest in. So there's lots to go at but liquidity -- the illiquidity is what creates the opportunity as well. Typically, high-liquid ETFs that kind of theory, trading discounts, NAV, they don't because higher liquidity there's a very effective arbitrage mechanism. So the illiquidity is the source of the opportunity as well as the source of risk. So absolutely, there are times when holding a liquid is highly risky. But what we're seeing now and we're being asked about our top contributors but the trusts that are moving most dramatically are the ones that are at least liquid. And then a small change in demand leads to a large change in price. So maybe I don't know if I jumped ahead...

You are entitled to answer that question as well. So someone has asked us what the top 5 contributors and detractors over the last quarter. Where? I'm not sure if we have that data to hand, but I'm sure...

No. But we can certainly get it to you. But there's been a property has an infrastructure contributed strongly to the performance holdings in Japan and the U.K. contributed, but we can certainly come back.