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

Well, thank you very much indeed for coming. It's wonderful to see you all here. Lots of familiar faces, some new faces. So I was reflecting on the fact that in 3 months' time, it will be 10 years since I joined CG Asset Management, 10 years since I started work as then a much more junior manager of this Trust. And perhaps on another occasion, you'll indulge me and I can talk to you a little bit about the experiences that I've had. But for the time being, suffice it to say that it has been the most stimulating and rewarding 10 years of my life. And among the many things that Peter has said to me over the years that have stuck, there was something that came to me this morning, which he said actually before I joined CG and since it has been over 10 years, you'll forgive me that I am paraphrasing at the margin, but it was this. Capital Gearing Trust is where substantially all of my money and my family's money is invested. And anyone who wants their money managed alongside us is welcome to join us. And Capital Gearing Trust is exactly that. When you buy a share in Capital Gearing Trust, you become our partners and you sit alongside Peter and Alastair and me and my mom and Peter's children and all of the CG team and the Board and our friends and our colleagues. And we're incredibly honored that you place your trust in us, and we will do our utmost to uphold it. Our promise to you is that we will work diligently and thoughtfully on your behalf. And as your partners, we will enjoy the successes with you and also share in any failures. So today, I wanted to share with you what we've been up to over the last year. And of course, it's your opportunity to question us on what we've been doing. And we really, really value your questions. Please ask them here at the end of this session or indeed next door. We'll be delighted to talk to you for as long as you want. So we'll skip over the disclaimer, I think we can do without that today. The Chairman has gone through the highlights, 4.1% NAV total return, 1.5% ahead of inflation. That is satisfactory, though I would describe it as adequate, but a not stellar vintage. For the Bordeaux lovers among you, I would say that it was more reminiscent of 2004 than 2005 or perhaps 2014 rather than 2015. Now you will have noticed that there's been a sharp increase in the dividend over the year. And before I talk about that, I need to start with a caveat, which is, of course, that I'm not here to give you tax advice and that if you have any doubt about your tax circumstances, you should seek professional advice. So with that out of the way, what has happened? Well, the Board have elected to stream the interest income that the company receives directly to you, our shareholders. This means that the company will no longer pay corporation tax on interest income that it receives but it also means that the distribution that you receive from the company is now made up of 2 components. One component is dividend income and the other is interest income. Now for those of you that are holding your shares in untaxed accounts, your ISAs and SIPPs, you need to give them out of no further thought and just enjoy the fact that the dividend has increased by about 30%. For those of you that are holding it in tax accounts, the situation is slightly more complicated, but I can assure you it is well worth it. And the reason for that is as follows: If we take, as an example, an additional rate taxpayer, the effective tax rate that you currently pay on interest income is about 55%. That is made up of -- or sorry, rather, that you used to pay before the Board made these changes. You paid 25% corporation tax within Capital Gearing Trust and you then paid 39% dividend tax on the residual. Going forward, in the new world, on the interest component of your distribution, you will pay 45% tax as it is classed as income. So overall, that is a material improvement. So our thanks to the Board for taking that initiative. Right. enough of the highlights. Here is the long-term track record of the Trust since we took over its management in 1982. And we'll move on now to positioning and returns. Here is our positioning. I don't propose reading out this slide and what's going on. Rather, let me tell you how our positioning has evolved since the end of the year. Our dry powder, and that is our term for cash, treasury bills, short-dated government bonds and credit has risen to 34%. That is substantially due to 2 factors. The first is that with the rebound in equity markets, we're becoming increasingly concerned about the elevated valuations of equities, particularly in the United States. And similarly, we have concerns over fiscal sustainability, which constrains our appetite for longer-dated government bonds. Our index-linked bond holdings have remained constant at around 38%. But within that, we have increased our exposure to U.K. index-linked bonds and reduced our exposure to U.S. TIPS. And the rationale for that is twofold. First, the yields available on U.K. index-linked bonds have risen to levels that we chose to be very attractive. And second, we have concerns over the outlook for the dollar given all that is going on in the U.S. at present. You will also note that a significant proportion of our remaining holdings in U.S. TIPS have been hedged back to sterling to protect against any depreciation -- further depreciation of the dollar. As Jean mentioned, all parts of the portfolio contributed positively with the one exception of our infrastructure holdings. However, we -- since the end of the financial year, those infrastructure holdings have performed extremely well, and we remain very confident that they will deliver very attractive returns over the medium to long term. And I would just point out that since the end of the financial year, the NAV total return is up a further 2.6%. Now we don't make any great claims to [ Genius ] What we're trying to do is develop a thoughtful, conservative asset allocation and then to do reasonably smart things with each subcomponent of the portfolio and eke out additional returns. And so I wanted to highlight a few of the ways in which we do that on this slide. So on the top left, you can see the single largest component of our dry powder portfolio is an allocation to hedged -- sterling hedged 2-year Japanese government bonds. And through the financial arcania of the cross-currency basis swap, we earn an additional 35 basis points return with respect to a comparable U.K. gilt of the same duration. Within our credit portfolio, the vast majority of our allocation is to liquid, short-duration investment-grade corporate bonds. But where we can see attractive opportunities, we will take on a bit of extra interest rate risk, credit risk or liquidity risk if we think that we're being handsomely rewarded to do so. And here on the top right is one such example. This was a bond which we purchased earlier this year, the Tesco index-linked bond of March 2036. And as you can see, that was offering nearly 120 basis points additional spread over a comparable nominal bond of a similar duration. So what this means in practice is that by lending to Tesco for the next 10 years, this Trust will earn 4% real, that's 4% above the rate of inflation. And we think that, that is a fantastic return given that we don't really have any serious concerns over the creditworthiness of Tesco over that time horizon. Now as you know, the largest component of our government bond holdings is invested in inflation-linked bonds. And we wax lyrical about the many reasons why we do that. But here is one of them. They simply offer better returns. So bottom left, you can see this is the return since the turn of the century of U.S. TIPS versus U.S. nominal bonds, and they have delivered a better return by 1.2% per annum on average for the last 25 years. That's a cumulative additional return of 80% since the turn of the century. And then finally, as you know, one of our specialisms is trying to exploit discounts in the investment trust market. And here is an example from the last year. Perticap Financials Trust was our second largest conventional equity investment trust position. And we were able to purchase this on discounts ranging from between about 8% to 10% in the early part of the spring of last year. Safe in the knowledge that this was a vehicle with a fixed life and that we would have the opportunity to redeem our investment at something very close to NAV almost exactly now this year. And sure enough, you can see the results. Over the course of the financial year, it returned 23%. That was 4% ahead of its underlying index. And why did that come about? It came about because the discount tightened in anticipation of the liquidity event that at the end of our financial year was just a couple of months away. So those are just a few examples of how we've been investing your money at a sort of more granular level. Taking a step back and looking at the portfolio at a slightly wider lens, you can see on the left the performance of our risk assets versus the Investment Trust Index. And you can see that over the last year, they have continued to outperform the Investment Trust Index. In particular, we were really pleased to see how well they held up in the turbulence that we saw in the early part of this year. And indeed, the portfolio's resilience during the bear market, the brief bear market that we saw was very pleasing. So from the middle of February to the middle of April, the MSCI world in sterling terms fell by about 21%. Over the same period of time, the NAV of the Trust fell by about 3%. So we were really showing the defensive characteristics there. On the right-hand side, you can see the performance of our bond portfolio over the last 10 years and where we've put some really serious blue water between ourselves and [ Sterling Ag ] Sterling Ag is a broad diversified portfolio of sterling-denominated government bonds and corporate bonds. And that outperformance adds up to about 48% today. Sometimes people ask why we spend so much time comparing our performance versus the Investment Trust index. I would say that there are 2 chief reasons for that. The first is that it is the pool that we principally fish in, and we need to always be making sure that we continue to outperform it as we go along. But second, as this chart demonstrates, it has been a very strong performing index over the long term. However, you will note that in the last couple of years, it has lagged the MSCI world. Now there have been 2 principal reasons for that. The first, of course, is that, as I'm sure you're all aware, discounts in the investment trust market have widened over the last couple of years. The second is that the Investment Trust index is structurally underweight U.S. equities and in particular, structurally underweight the Mag Seven. For reasons that Peter, I'm sure, will elucidate in his talk, we expect those 2 lines to converge in the coming years. So we're very comfortable that we have the majority of our risk assets invested in the investment trust market. Finally, let's just take a 10-year view. Over the last 10 years, the trust has outperformed PIMFA conservative, and that's probably an appropriate benchmark for an investment with a similar risk appetite. And also, we've outperformed inflation by about 2.3% per annum. So the total return for the Trust has been 5.3%. Inflation has averaged 3% over that period. Now that is -- that outperformance is at the lower end of the range that we would judge to be acceptable. However, we would also point out that over this 10-year period, we have had negative real interest rates for the vast majority of that time. And laterally, we have been through the largest bond bear market in history. So that outperformance has been satisfactory, but we are confident that we will be able to increase the level of outperformance with respect to inflation over the next 10 years. And on that note, I will pause and hand over to Peter, and he will take you through the outlook. Thank you very much.

Thank you, Chris. Very nice to see you all this morning. So we presented this chart to an institutional investor quite recently. And the comment that he made was there seems to be plenty of alpha about you outperforming the investment process clearly works well. But obviously, you haven't had nearly enough in American Equities and in America [indiscernible] And what I thought I would do now is give you some color as to why that was true and why we continue to be very underweight to those assets. Obviously, the underlying reasons we think that the S&P is capable of a very large form. But this falls into 2 parts. So one is the continued overvaluation of the S&P 500 and the other is the fragility of the world economy. But to stick with the first, this is the chiller earnings yield for the S&P 500. And you can see that the return is extraordinarily low. And to just update those numbers, the earnings yield is now down to 2.67%. And actually, both asset classes have done well in the last -- since it's printed, and the TIPS yield is 2.5%. So the level of that for equities is extraordinarily low. It was slightly lower in 2000. It wasn't as low as this in 1929, but it is certainly an alarming level for us. In 2021, it was roughly the same as where we are now. And the at the time, you could just excuse that because the alternative to buying equities was to buy bonds and they had negative real yields at that stage. So there was a lot of talk of [indiscernible]. There is no alternative to equities. But the sure is now. And at current rates, I think it's fair to say that the retail enthusiasm that has driven markets to new highs is applicable only in terms of momentum and easy financial conditions. And that confidence has been reflected in the mantra of BTFD which I'm sure you all heard of, which is By The F——____ Dip. I'd say poor is the return here that the only a very modest reversion to the mean will produce negative or 0 real returns over the next 10 years. You compare that with the 2.5% available on TIPS. The relative attraction is obvious. 2.5% is just worth noting is in most modeling, pretty attractive. So traditionally, real yields are associated with long-term growth in GDP or in productivity. And the CBO's forecast, for instance, for the long-term numbers for both of those is significantly below the TIPS yield now. So it's pretty attractive, but we'll get to why you have to be careful in a minute. But it doesn't matter what ratio you use to judge the value in the U.S. The dividend yield is 1.2%. It trades at a record 3x sales. The current earnings yield is the same as the 10-year treasuries below corporate bonds and the market cap is a record level of GDP. One unusual aspect of the last 15 years is the persistence of the domination of the largest companies from 2010. So since 1960, in each decade of the top 10 or 15 companies by market cap, roughly 15% had fallen out of that category in the subsequent 10 years. But today, the market share of those that were at the top in 2010 has actually grown. Of course, big tech has been allowed to buy up its potential competitors that may have been helpful. And they have large apparent moats. But the same claim was made for oil companies, for telephone companies and chemical companies for different periods, different decades in the past, and it turned out to be rather fragile. And at a time of rapid technological advances, it seems brave to assume that the winners of the future are even quoted today. Now it's true that values do look better outside the U.S. and our equity exposure is weighted accordingly. However, history suggests that if we get a crash in the U.S., then correlations go to one. So you're not really defended by being elsewhere. And what might be the catalyst for such a setback? I mean bull markets do not normally die of old age. It usually takes either recession, which is possible next year, but not I think likely in the U.S. or sharp changes in interest rates, which leads on to the fragility of the world's financial structure. Since the beginning of the century, the emergence of China, in particular, aided by the policies of a newly reunified Germany has led to deflationary price pressures and an ex anti-desired savings surplus for the world. And in response to that, governments and central banks have used fiscal and monetary stimulus to avoid the recession that's implicit in that. With the result that government debt has risen as a percentage of GDP at a rate which has been unparalleled, and you can see on the left-hand side, in peace time. Nominal debt in the U.S. is 112% of GDP, plus 10% for state and local and over 114% in France. The U.K. is actually better, but the dollar is still a reserve currency. And France has the comfort of backing from the ECB. And the U.K. depends on the kind of strangers. Furthermore, deficits, you can see the U.S. on the rise, but budget deficits are notably and quite inappropriately high for fully employed economies. So roughly 6.5% in the U.S., 5.5% in France. And the U.K., well, who knows. We'll look at that later. But before we get on to it, I just want to consider the term premium. So this is the difference between yields at the long end of the bond market and the 10-year and is a very good indicator of confidence. So that relationship has risen recently. You can see on the right-hand side, there's a tick up, but we are concerned that it might get much higher. So term premium, I don't mean to be too technical, but it depends on the buying of long bonds, let's put it that way. It depends upon the confidence in fiscal discipline over the medium term, the rate of inflation and its development over that period, the estimates of neutral short rates, the financial structure of the market, including its geopolitics and not irrelevant recently, the sheer volatility at the long end, which itself demands a high premium. But the most important variable is expectations for inflation. And currently, there is an astonishing complacency, I would view it in the United States that the PCE deflator, which is what the target is will come in at 2. That's what's priced into TIPS. But actually, the chances of a solution to what is clearly an unsustainable debt level not including inflation, i.e., we think it has to include inflation to succeed. The chance of not including inflation are very low. And if the market even partially arrives at our conclusion, then the term premium could be very much higher. And the U.K. is certainly very fragile in this respect. We saw yesterday, it's extraordinary [indiscernible] question time, where it appears that the simple fact that the Prime Minister did not support this chancellor produced a 4% fall in long [indiscernible]. So that's a huge move for a bond market. It has recovered most of that since he's now declared his undying support for her and all going well. But if we look at the U.K. position, so the deficit in the U.K. was 5.2% last year and was forecast in the autumn to 4% to 3.6%. But with supposed revenue raising items like taxing non-doms and education, both seemingly having backfired, the U turn on welfare and the winter fuel payments, a lower growth rate than assumed and a higher starting point. Not to mention a record low headroom in that forecast. And finally, the persistent overoptimism by the [ ABR ] and we are expecting again adjustments in the autumn because their growth rate, in particular, is significantly higher than the consensus. The treasury faces a lot of challenges. So we're clearly getting to a point or close to a point where demand for government bonds runs the risk of just being insufficient for the number of bonds that are available. Confidence is absolutely essential at the long end. We've already seen a significant reduction in demand for long treasuries and gilts and issuance has been shortened quite significantly over the last year in a number of steps. And actually, within the last week, we've had both Scott Bessent and Andrew Bailey talking about in terms of lack of liquidity at the long end and how they're going to shorten the issuance. Often, this is dressed up. I remember the DMO making announcement that having failed to issue a 49 bond quite recently that actually, you don't want to raise money anyway at these sort of interest rates. But it's clear what's driving it is not that view. It's lack of demand. So hardly anyone believes that the debt levels are sustainable. Plenty of people believe that they can have fun until that becomes evident. So Jamie Dimon, the CEO of JPMorgan, says he doesn't know whether the crisis comes in 6 months or 6 years. We've had about 2 weeks of that period. And obviously, nobody knows. We don't know either. But what we do know is that with very poor prospective returns from equities and with the high likelihood of a crisis initiated in the bond markets, over the medium term that we need to have an asset allocation that will protect portfolios, the value of your portfolios against such volatility. I stop there, and we'll take questions. Chris, do you want to come up?