Law Debenture says tax changes will hit its distributable income

Law Debenture says its net asset value total return for the year to 31 December 2016 was up 16.9%, compared to a total return of 16.8% for the UK market. Revenue return per share was 18.56p (excluding group charges of 2.60p), an increase of 2.5% over the previous year, as a result of a 1.2% decrease in the investment trust and a 8.3% increase in independent fiduciary services.

The board is recommending a final dividend of 11.5p per ordinary share (2015: 11.0p), which together with the interim dividend of 5.2p (2015: 5.2p) gives a total dividend of 16.7p (2015: 16.2p).

With effect from 1 April 2017, HMRC will cap the amount of UK tax relief that is available for distribution within a group to the higher of 30% of taxable earnings before interest and depreciation and GBP2 million net UK interest expense per year. Law Debenture generates tax relief at the investment trust level arising from the long term debt interest and excess costs. The unutilised reliefs can be transferred to the IFS businesses, thus reducing their tax liabilities. The new rules limiting the amount of unutilised relief that can be passed down in this way will have an effect on the IFS businesses, increasing their tax charge in aggregate by c.GBP600,000 per annum (GBP450,000 in 2017), which reduces the profits available for distribution to the investment trust by that amount.

The investment manager’s report discloses the companies that had the biggest impact on the fund’s performance during the year.

Positive contributions

1    Royal Dutch Shell         GBP8.6m
2.   Anglo American            GBP7.1m
3.   Rio Tinto                 GBP6.2m
4.   Applied Materials         GBP6.0m
5.   Glencore                  GBP5.9m

Negative contributions

1.   Cape                               GBP2.2m
2.   Senior                             GBP2.0m
3.   International Consolidated         GBP2.0m
4.   Interserve                         GBP1.9m
5    St Modwen Properties               GBP1.5m

They say that, overall, the performance of the portfolio was good and they outperformed the benchmark index and were in line with the average performance in the AIC Global sector. Nevertheless, relative to other funds in the Global sector, they were in the lower quartile for performance over the year. The main reason for that was their weighting in the UK.

In the latter part of 2015, they built up a position in the large miners Anglo American, Glencore and Rio Tinto. These shares were trading substantially below their asset values but they believed they had been oversold and that the strong management in the companies would quickly deal with the issues facing the sector to deliver a recovery. This proved to be an accurate call and 2016 saw a strong upturn in the fortunes of these companies. They took action including selling their poorer assets, closing underperforming mines, having capital raisings and initiating modest production cuts. As a result of these actions, coupled with continued global growth and economic stimulation measures taken by the Chinese authorities, raw material prices recovered from very low levels and share prices rose quite steeply. The fund benefited from this and during the summer months, decided to reduce the exposure, selling entirely the holdings in Glencore and Anglo American. They believe that their purchases were well timed but the sales were not as the prices of raw material kept going up – for instance, coking coal prices doubled in a six week period – thus propelling the share prices substantially higher still in the fourth quarter of the year. The holdings in the sector were further reduced into this strength. The stimulus that contributed to rises in raw material prices may however be stirring inflationary pressures, so the authorities may have to intervene again in the future and weakening raw material prices may return. Therefore, they say they will continue reducing further into share price strength.

The US was the best performing region in 2016, delivering a total return in excess of 50%. Energy and manufacturing stocks performed well, particularly towards the end of the year when markets began to anticipate the upside that might materialise from Trump initiatives to reduce regulation and stimulate economic growth. This has led to some very high valuations and as a result, they have reduced Applied Materials and Cummins while building up a holding in General Motors.

During the year, they re-configured our exposures in Japan and the Far East. Exposures to Henderson Japanese and Far Eastern OEICs were sold and replaced with a new holding in Schroder Japan Growth Investment Trust, which was bought on a reasonable discount, and increases in their holdings in Scottish Oriental Smaller Companies and Templeton Emerging Markets, the latter having performed particularly strongly since being added to the portfolio in 2015. However, Better Capital, the investment company that is involved with corporate turnarounds, severely disappointed as some of the underlying holdings experienced continued poor operational results. The company responded to pressure and is now returning capital to its shareholders.

The rise of populism, illustrated by the Brexit vote in the UK and Donald Trump winning the US Presidential race, has suddenly thrust politics into the forefront of investors’ thinking. After the Brexit vote, they reduced equity exposure in the UK, as uncertainty about the economic outlook became a greater concern. Share prices have recovered from the initial falls after the vote, but sterling’s weakness has increased the prospect for inflation to rise during 2017. It is possible that inflation will rise faster than wages, which will put downward pressure on consumption – the consumer having been a significant factor in better than expected growth figures in the second half of 2016 – with the UK retail sector possibly suffering as a result. The portfolio has very little exposure to this sector. On the other hand, if wages rise faster than inflation, this might suggest that inflation is becoming more embedded in the economy. It may become necessary for interest rates to rise from current historic lows. While this would help savers, the adjustment to higher rates will be painful for consumers and consequently for some parts of the economy.

Although there are concerns about the UK, the case for equity investment remains strong. The board and the managers continue to believe in the long term benefit of investing in equities and of the investment trust structure. The UK market has a higher dividend yield than other major markets and around 70% of the profits of UK companies are derived from overseas. These profits in sterling terms have received a large boost from the fall in the pound, as have the dividends received from UK stocks that pay their dividends in Euros or US dollars. Higher dividend yield and higher dividend growth than other markets drives their belief that the portfolio should hold a substantial weighting in UK stocks, despite the concerns described above.

LWDB : Law Debenture says tax changes will hit its distributable income

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