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Scottish Investment Trust adopts contrarian approach

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The GBP863 million Scottish Investment Trust was founded in 1887 but has recently undergone something of a transformation under the care of Alasdair McKinnon (pictured) and his team.

McKinnon explains that 2014 saw the board decide to take stock and rethink their position. “The board asked what is the future of the fund management industry and decided that just offering there or thereabouts performance was not good enough. The rise of ETFs gave them concern. “We said, ‘why would you buy an investment product by an active manager that wasn’t that different from an index, when you know what you are getting and that the costs will be lower with an ETF. Active managers on average underperform indexes because of the cost.”

The outcome of the internal debate was a decision to not be an ETF but to do something very different. McKinnon says: “What works, and where we got to, is that the biggest pressure on a professional investment manager is the pressure of short-term performance often relative to a prescribed benchmark. We should use the advantage of the closed end nature of the structure and the advantage of making profits for a longer-term investor using a contrarian style.”

He defines contrarian by first observing that humans like to be part of the crowd. “However, in financial markets, you have to rip it all up and say ‘if I always do what the crowd is doing I won’t beat the crowd’. You have to think differently.”

The result was that they cut the number of holdings to 54 and focused on contrarian investment. “Being a contrarian is difficult because you are buying stocks that people don’t like and selling stocks people do like,” he says.

“Most investors buy at the top and sell at the bottom – because people get involved in themes and trends after they have done quite well and sell after a sustained period of poor performance. Its understandable human behaviour.

“We recognise that cycle and manage how we think accordingly. We say ‘how can this company improve from here?’ Understanding the cycles in company or industry earnings and capital cycles is very important to the process.  We look at companies that are doing really well now and ask what can knock them off course. We also look at potential for improvement – where people can be positively surprised – and for belt and braces which is support for our companies to survive the cycle – such as a strong balance sheet and a plan B.  Also, a higher than average and sustainable dividend return can pay us while we wait.”

McKinnon and his team use 3 categories to identify their investments: are ‘ugly ducklings’, companies that have done badly and because of that everyone has got depressed about their prospects; ‘change is afoot’ which covers ugly ducklings that have already made substantial changes to the business model but the market hasn’t caught up and finally ‘more to come’ – companies that have often transitioned through the previous categories but still have potential to attract more interest from investors.

The firm has adopted the contrarian approach for the last two years and had a very successful 2016 which put them at the top of the league tables, while this year, performance has run in line with the relevant indexes.

His colleague Sarah Monaco gives examples of each category, with Marks & Spencer sitting in the ‘ugly duckling’ category, very unloved since its peak 20 years ago and now wrongfooted by fashion habits. She points out that the food business is great and sensible steps are being taken to turn around the clothing segment.  UK retailing generally has been under the cosh because of discounters, the rise in on line retailing and the fallout from Brexit.

However, the team feels that there has been an over-reaction and the arrival of turnaround king Archie Norman as the new chairman is a good sign for future recovery. The stock also offers close to a 6 per cent dividend yield which pays them whilst they wait for the turnaround.

Another example of their contrarian approach is ‘change is afoot’ company, Treasury Wine Estates which was spun out of Fosters and has endured a difficult time and a long wine cycle that had turned against it. 2014 saw a new CEO arrive from Coca Cola who said that wine should be marketed as a fast-moving consumer good and has expanded margins and branding. Monaco says the stock is transitioning categories after strong performance, however there is more to come in the recovery of this stock.

An example of a ‘more to come’ stock is Nintendo, which Monaco says changed its management strategy to allow games to be played on mobile and brought in a new console, for which demand outstrips supply.

Finally, with sell discipline being equally important to the process, a big turnaround story that has now transitioned out of the portfolio comes from Microsoft. “Fears that the era of the PC was over had weighed heavily on the company.  A new management team changed the model and saved the company by making it more of an annuity model,” Monaco says. “It went through all of our categories and we sold it in March this year.”
 

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