Our contrarian investor has eyed up an underperforming investment trust top-heavy with tobacco stocks, while there's also a bargain to be had in Japan.
The philosopher Isaiah Berlin once observed: ‘How few are the lucid intervals during which reason can function freely, and how fruitful it is and how beneficent when it is freed.' A contrarian approach does indeed work best when the investment world goes deep into one of its irrational phases and the contrarian can exploit the consequent valuation anomalies.
Can we accuse investors of being in such a phase at the moment? The case for the prosecution is that valuations are stretched – at least in the US, where the equity market at the end of March traded on a historic price/ earnings ratio of 23.9 times, a forward p/e of 18 times and a price to book of 3.1 times. Meanwhile, political risk and geopolitical tensions are heightened, suggesting that investors should apply a higher discount rate to future earnings. The S&P 500 has had a strong run: it has more than doubled over the past seven years, an annualised return of more than10 per cent, excluding dividends.
A defender of the rationality of current valuations would probably say that politics rarely matters much, except over the very short term; that the global economy is in a rare, for the recent past, sweet spot of co-ordinated growth, with Trump-initiated tax cuts and infrastructure spend still to come; and that, as a result, earnings will grow to justify current valuations. Above all, animal spirits, so long in hibernation, have been unleashed.
And they might add, perhaps, that US markets nearly always seem expensive and that UK equities are on a high dividend yield of 3.5 per cent, above the average for the past 20 years and especially attractive compared with10-year gilts yielding just 1.16 per cent.
We can't be certain that we have reached the heights of irrationality, but it must be probable that we are some way up the irrationality incline. At Ipso Facto, we think it's time to have a balanced portfolio, be nimble and concentrate on well-managed trusts that are somewhat out of favour. One such trust is Edinburgh Investment Trust (EDIN), which has one of the least economically sensitive portfolios. Relatively poor recent performance – over the year to end March its net asset value increased by just10.5 per cent, compared with18.1 per cent for the FTSE All-Share index – comes with an attractive discount of 7.1 per cent.
Its underperformance is evidence that the trust's portfolio has not been exposed much to cyclicals and commodities. It is true that its top holdings are not exactly cheap–the top five are Reynolds American, British American Tobacco (which is acquiring Reynolds)and BP, as well as Imperial Brands and Altria, two other tobacco companies. But the prodigious cash generation of the tobacco sector has been highly valued by investors in uncertain times.BAT is on a historic p/e ratio of 21.5 times, pretty punchy for a sector where there is little growth. If the wheels do come off the Trump-led reflation story, investors may turn to these defensives in great numbers.
If on the contrary, the global economy continues to motor ahead, there is some consolation to be had in the near-3.5 per cent dividend yield that, barring a catastrophe, should easily be sustained. The similarly managed Perpetual Income & Growth Trust would do much the same job.
As a counterpoint to the defensively focused Edinburgh, we want our second choice to have a bit more economic vim in its portfolio.
We could turn to Temple Bar, which has some good banking and oil and gas exposure. Alternatively, and in view of consumer prices index inflation rising to 2.3 per cent in the year to February 2017, we could go the whole way and opt for BlackRock Commodities Income which, although volatile, is now on a healthy discount. Some form of inflation protection should be in investors’ minds. Our compromise is
JPMorgan Claverhouse (JCH), a solid equity income trust on a 3.5 per cent dividend yield with a discount of around 9 per cent. Its top five holdings are Shell, HSBC, BAT, BP and Rio Tinto.
Searching for value outside the UK, it might seem perverse to look to Japan at a time when North Korea is firing missiles into nearby waters and US warships are steaming to the region, but we think Japan has some attractive features. It should benefit from renewed economic strength in Asia generally, while being less prominent in the global trade firing line than China.
Investors are still significantly underweight in the third largest economy in the world, hence valuations are attractive. In particular, the MSCI Japan index has an undemanding 13.9 forward p/e and a price to book of 1.3 times. This compares with2.3 times for the MSCI World index.
The consistent top-performing Japanese investment trusts come from Baillie Gifford. However, Baillie Gifford Japan and Shin Nippon trusts stand at premiums, so we plump for Aberdeen Japan (AJIT), on a 14 per cent discount.
The author is founder of investment trust advisory service IpsoFacto (www.ipsofactoinvestor. co.uk), which offers a free two-month trial to new subscribers.