Interactive Investor

Don't overlook US-focused trust opportunities

28th July 2014 10:44

Fiona Hamilton from interactive investor

The US stockmarket accounts for more than half the MSCI World index, compared to less than 16% each for Asia including Japan, developed Europe and the UK. It is hugely diverse, includes global leaders in many fields, and has reasonable corporate governance.

It therefore seems surprising that almost all global trusts are consistently underweight the US, and that there are very few US investment trusts.

It is a lost opportunity, because the S&P 500 index has gained around 130% in sterling converted terms over the last five years, well ahead of the FTSE All-Share and the Europe ex UK indices, which have been the runners-up.

Over three years it is similarly well ahead, although over one year it has lagged Europe ex UK, partly due to dollar weakness.

Economic recovery

With US GDP at an all-time high, hopes among commentators that its recovery is gaining traction, and indications from the Federal Reserve that it expects to hold interest rates down through much of 2015, those who have missed out may be tempted to jump on board. Before doing so, they should note that the S&P 500 index can reverse violently.

Having risen relatively steadily from 1982 to 2000, it fell around 46% in dollar terms in the three years to March 2003. Over the next five years it more than recovered to a new high, but in 2008 it again fell over 40% - though a strengthening dollar halved the fall for sterling investors.

Its latest five-year rally has lifted it to a fresh peak, and Jeremy Grantham of Boston-based GMO Woolley - a respected strategist with a reputation for identifying dangerously over-rated stockmarkets - believes it could go higher still before 'the inevitable retreat'.

But that begs the question of whether the next significant correction is still some way off, and whether it will be limited to around 10%, as in summer 2011, or be severe - as suggested by GMO's calculation that US equities are more than 65% overvalued.

Robin Angus of the global Personal Assets Trust tends towards the more severe outcome, on the basis that the S&P 500 has risen nearly 50% over the past two and a half years, compared to a rise of around 12% in earnings per share.

"The expectation that material earnings growth will be delivered by the current hesitant recovery is, we believe, at best premature and at worst mistaken," he opines. He says the trust is waiting to raise its current 44% equity exposure when prices have fallen to much more attractive levels - but interestingly half its existing holdings are in US stocks.

Asset allocation

Martin Currie Global Portfolio Trust has the highest US weighting of any global trust, at 52% of total assets. Manager Tom Walker says this is partly because he does not want performance to be impacted by diverging too far from the index in terms of asset allocation - preferring to rely on individual stock selection for outperformance - but adds that he can't think why so many of his peers have been so underweight.

"There are lots of overvalued companies in the US market, as there are in other markets, but it offers an exceptionally wide choice and the quality is by and large high. Valuations are getting stretched, revenue growth has been hard to achieve and corporate margins are already high.

"But I think some US stocks can re-rate more, because quantitative easing keeps creating more money, the cash has to go somewhere, equities look attractive relative to cash and bonds, and the US stockmarket looks attractive relative to most other regions, especially emerging markets and Europe - where I am cautious of the recovery in banks and in the peripheral regions."

Andrew Bell, who has achieved above average three-year returns as manager of Witan Investment Trust, is also guardedly positive. This seems surprising, given that Witan's US exposure is only 23%, but Bell reveals that the five global managers to whom he has entrusted over 40% of Witan's assets have US weightings ranging from 75 to 43%.

"On a pure valuation level, the US stockmarket looks ambitiously priced, but if growth prospects are taken into account it looks more reasonable, as it has more money-making potential than other regions. Also, it includes a lot of interesting companies, so good stockpickers should be able to do well out of it," Bell says.

However, as his overall asset allocation indicates, he is alert to opportunities elsewhere. "If, in the next year, people are surprised by the strength of world growth, they may do better in Japan and emerging markets than in the US, as less optimism is priced in."

Alex Crooke, who has enjoyed a good recent run as manager of Bankers Investment Trust, has similarly mixed feelings. He expects US growth to stay strong, but has restricted Bankers' US weighting to 20% (as against a mid-20s norm) on valuation grounds.

Blue-sky US stocks

"We can buy into multinationals with similar businesses to many US companies on lower valuations elsewhere. Blue-sky US stocks look very expensive, while the share prices of ultra defensives such as utilities, real estate investment trusts and consumer staples have been pushed up by the search for income. We are finding the best value in areas such as industrials and established technology companies, which should benefit from ongoing growth in the economy," he says.

The choice of actively managed US large cap trusts was increased to three by the May 2012 conversion of Aberdeen's Edinburgh US Tracker Trust into the North American Income Trust and the October 2012 debut of BlackRock North American Income (BRNA). Both have disappointed so far.

The managers of the BlackRock trust have an impressive 10-year record, but have been less successful during the strong bull market. Their focus on higher-quality, cash-rich, dividend growth companies with defensible competitive advantages could come into its own when worries about rate increases undermine the enthusiasm for more cyclical sectors. Meanwhile, the trust offers a 3.7% yield paid quarterly, and the discount is protected by six-monthly tenders.

JPMorgan American Trust is much the largest and best established trust in the sector. Its net asset value total returns have been ahead of the S&P 500 over one and 10 years, but its three-year returns suffered from over-cautious use of its gearing facilities following the 2011 correction. The board has therefore stipulated that gearing should be 8 to 12%, unless there is high conviction to the contrary.

It has been managed since 2003 by New York-based Garrett Fish. He says a correction of at least 10% in the S&P index is overdue, but he is nonetheless positive about the medium-term outlook for both the US economy and the US stockmarket.

His confidence in the economic outlook is based on factors such as a strengthening but still very affordable housing market, improving consumer finances, rising capital goods orders and strengthening demand for corporate loans.

Growing stockmarket?

He says soaring US production of petroleum and natural gas should keep gas prices low for up to 30 years, which is good for consumers, hotels and all sorts of industries, and points out that the US economy is more dynamic since the financial crisis as costs have been cut.

"Profit margins are at an all-time high and will fall eventually, but companies have refinanced their balance sheets, locking in low interest rates, and US manufacturing unit labour costs have been in a sideways channel since the early 1980s. No other country has been able to keep manufacturing unit labour costs steady for 30 years."

A growing economy may not translate into a rising stockmarket, especially if strong growth is already discounted. However, Fish believes US shares are not grossly overvalued. He says the average forward price/earnings (P/E) ratio of 15.2 is a long way below levels reached in the late 1990s, and not hugely above its long-term average of 14.9%. If GDP rises as he expects it should bring the average down.

As to worries about rising interest rates, he says: "History shows that if 10-year Treasury yields are below 5%, rising rates are generally associated with a rising stockmarket. So a rise is not a threat to the bull market."

His portfolio is focused on high quality companies "which are on sale". On average, their forecast earnings per share growth is in line with the S&P index, but their forward P/E ratio and trailing price-to-free cash flow ratio are both well below the index average. If mistakes with gearing are stripped out, the trust has outperformed the S&P 500 most years since he took charge.