Morningstar® CEF Report™

Dunedin Income Growth Investment Trust DIG

Morningstar Analyst Report Fund Report for FSUSA08C3R Dunedin Income Growth

by Jackie Beard, 30/05/12

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Morningstar's Take DIG

Morningstar Analyst Rating™

Last Price

275.00

Current Discount

-0.84%

Last Actual NAV

277.34

Latest NAV Date

23/05/2013

Gross Gearing

108

Net Gearing

105

1 Year Z Stat.

0.87

Ongoing Charge (2013)

0.62%

Average Daily Shares Traded (1 Yr)

0.08m

Role in Portfolio

Core. The fund provides both capital and income growth and is particularly helpful for investors wanting regularity of income.

Executive Summary

Process: The firm applies a patient, value-based approach. Bottom-up security selection with a yield overlay leads to an unconstrained portfolio.
NAV Performance: Returns under Whitley’s leadership since 2009 have picked up after a difficult couple of years.
People: The pan-European equity team is stable and well resourced; the average experience among its members is close to a decade.
Parent: Strategic acquisitions have broadened Aberdeen’s product base but its Asia & GEM funds remain key.
Board: Despite a change in chairman in 2012, consistency has been maintained as the new chairman was already a non-executive director.

Morningstar Opinion

We think shareholders in Dunedin Income Growth are benefiting from a new manager.

We don’t usually like manager turnover and this fund has seen three named managers in the last four years. But the process in use throughout hasn’t really changed, which ensures some consistency of approach for shareholders. Although Jeremy Whitley has only been the manager here since July 2009, he’s no stranger to Aberdeen’s process. He joined the firm in 2003 through its acquisition of Edinburgh Fund Managers, which was Dunedin's investment manager at the time. Although Whitley wasn’t responsible for this mandate upon the acquisition, his first involvement with it dates back to the 1990s when it was run as separate geographic pools of assets.

Whitley spent time with Aberdeen’s Asian team in Singapore, the home of the firm’s equity investment process, before transferring back to Edinburgh, initially to the global equities team. A reshuffle in mid-2009 saw Dunedin’s previous manager Stewart Methven move to the global equities team and Whitley become head of the pan-European equities team; it was at this time that he took over here.

Whitley’s arrival followed some disappointing performance across the pan-European team’s funds, resulting from too heavy a focus on valuation and not enough on quality. For example, they bought into financials too early because they looked cheap in late 2007 and early 2008, only to see them get markedly cheaper by the end of the year. Whitley hasn’t changed the process, but he’s brought about a greater discipline in adhering to high quality.

Results under Whitley’s tenure have picked up. Although he’s only been named as lead manager for a relatively short time, we think he’s already made a difference and the team is performing better. Indeed, in 2011, this fund ended the year in positive territory, while its Morningstar UK Large-Cap Blend Equity category average fund lost money. What’s more, the risk profile of the fund has reduced; its standard deviation over one year (a statistical measure of risk) is some 3 percentage points lower than the category’s and over three years it’s in line.

Granted, the fund has risk through the use of structural gearing; investors can expect to see modest gearing in use at all times here as a result. But Whitley is using this well and he keeps liquidity in the fund to cover any put options he writes on stocks. He also writes call options and up to 10% of the fund’s income is generated through option-writing now.

Income is an important feature here and the board has managed to maintain the dividend at its current level for the last few years through dipping into the revenue reserve account. For investors who rely on their investments for income, this has been key.

The sound management and proven depth of expertise give us confidence, and we award the fund our Bronze rating.

Portfolio Process Approach

The team invests on the premise that share prices over the long term reflect underlying business fundamentals. Consequently, the bottom-up driven, unconstrained fund invests only in stocks that successfully pass through its quality screen and meet its stringent valuation criteria based on metrics such as price/earnings, price/cash flow, and net asset value, and, given this fund’s income mandate, stocks must also have a healthy dividend yield. Quality is assessed on the basis of clarity in a company's business strategy and execution resting in the hands of experienced top management. Strength of balance sheet, transparency of earnings, and a commitment to shareholder value are other traits for which the team searches. Companies are deemed attractively valued if they appear to be trading cheaply relative to the valuations of similar companies based on ratios such as P/E and P/CF. This focus on quality and valuation renders the team members unwilling to pay too much for growth or chase momentum. It also means they are willing to go against the grain and buy into sectors or companies that are out of favour. The average holding period for the portfolio is three to five years and annual turnover is extremely low at just 15%-25%, helping to reduce dealing costs.

Portfolio Positioning

In keeping with most Aberdeen equity funds run by the pan-European team, the process leads to a portfolio that is heavy in large caps, with no strong bias to value or growth when looking at its placement in the Morningstar Style Box. Sector positions are largely the result of the team’s bottom-up analysis, rather than a macro view. The team has avoided miners and banks, as they have concerns over their quality and lack of yield. Conversely, they favour sectors such as pharmaceuticals and utilities for their yield, but also for their strong balance sheets. Indeed, the fund was more than 6 percentage points overweight in utilities at the start of 2012, compared with its category average fund. The team has been actively diversifying the source and quality of income from the fund’s holdings, to reduce reliance on such holdings from hereon.

Dividends

The board has moved to a quarterly dividend payment cycle effective Aug 2012. They view the income stream as an important factor at this fund and have dipped into revenue reserves in recent years to maintain the level of the dividend. Whitley sells covered puts and calls to generate extra income and this income accounts for up to 10% of the fund’s total income in any one year. Calls are covered by existing stock positions and puts by cash or the loan facility. Despite using reserves, there are still sufficient funds to cover the dividend at its current level for more than 12 months.

Discount

The board has shareholder approval to buy back shares when they deem it appropriate and last used this toward the end of 2008 when the markets were plummeting and the discount widened into double digits. Since then, and under Whitley’s leadership, the discount has stabilised in the low-single-digit range, and in recent times we have even seen it move to a premium. The fund’s three-year average discount is less than 5% and over the shorter term it’s even lower, at less than 3%.

NAV Performance Analysis

The fund struggled in the market downturn of 2007 and 2008 and this was common across most of the team’s mandates, as they bought into stocks that met their valuation criteria for being cheap, but then got cheaper when markets collapsed in late 2008. Whitley’s arrival saw the team refocus on balance sheet strength and quality of earnings and this has followed through under his tenure, albeit it’s a relatively short period of time. Since Whitley took over in July 2009, the fund has returned more than 19% annualised, compared with the category average fund’s 14.8%. Granted, Whitley arrived as markets were in an upward trend but it was in 2011 that the quality focus paid off: While the average fund in the category lost more than 5%, DIG gained 1.4%.

Risk & Return

While this fund carries structural gearing, its risk profile has been kept well in check under Whitley’s leadership and not at the expense of returns. In the short term, the fund has exhibited a risk profile that’s lower than its average category fund, when looking at its standard deviation (a statistical measure of risk). The fund has participated well in up markets and experienced less downside in down markets than peers.

Fees

Fees are competitive at this fund. Aberdeen charges an annual management fee of 0.45% on the first GBP 225 million of assets, 0.35% on the next GBP 200 million, and 0.25% on amounts exceeding GBP 425 million. There is no performance fee. This equates to a TER of around 0.7%, compared with a TER of 1.2% for the category median fund.

Gearing

The fund has a fixed-term debenture of GBP 28.6 million that redeems in 2019; thus, gearing is a permanent feature here until that time. The board has also approved the use of an overdraft facility, up to GBP 20 million. Whitley ensures there is sufficient liquidity in the fund to act as a backstop on any put options he writes. Typically he keeps gearing in the range of 5% to 15% of total assets. Decisions are left entirely to the manager, subject to the absolute range set by the board, and Whitley sees flexibility as a key factor in his decision-making process. He doesn’t use gearing to try to time the markets and takes a fairly conservative approach.

People

It’s rare for an Aberdeen fund to have a named manager as the reality is that all the firm's UK equity funds are managed by the pan-European equities team; it’s at the board’s insistence that there is a named manager here. Until March 2008, this fund was run by Yoon-Chou Chong but on his relocation back to the group’s Singapore office, management passed to Stewart Methven. Just months later in 2009 Methven moved to the global equity team and Jeremy Whitley took over. Whitley joined the firm through the acquisition of Edinburgh Fund Managers in 2003 and is no stranger to the investment trust structure. He has led the pan-European equity team since July 2009, having moved across from the global equity team. Although we don't like to see management turnover, we don't believe these changes have negatively affected the fund, the team, or the process. The team has a relatively flat structure comprising 17 investment managers and analysts; 10 are based in London, six in Edinburgh, and one in Paris. Analysts are hired early in their career arcs and trained comprehensively in the group's approach. This helps in applying Aberdeen's investment process consistently across all levels. In general, each member of the team spends at least half of his or her working day on proprietary stock research, with senior members increasingly involved in portfolio construction.

Parent

Aberdeen Asset Management started from humble beginnings, launching a GBP 50 million investment trust in its namesake Scottish town in 1983. The firm is now a truly global asset manager with investment offices in Europe, Asia, and the US, and more than GBP 175 billion in assets under management as of Sept 2011. Growth has been achieved organically and through a number of acquisitions including in recent years property-fund purchases. Sensible, strategic acquisitions have diversified Aberdeen’s investment base; it now comprises 15% in property and 30% in fixed income, and the remainder is allocated to equity products. Aberdeen is particularly prominent in Asia and a majority of its equity exposure is invested in the region. Furthermore, the investment process developed by Asian team head Hugh Young was adopted firmwide in 2002. Portfolio decisions are made in a collegial manner and Aberdeen for the most part avoids cultivating so-called star fund managers in contrast to some peers. Aberdeen’s fund managers’ remuneration is somewhat unique in the sense that it encompasses a largely subjective element. Although fund unitholders’ interests would be more directly aligned with fund managers' if the managers were rewarded by performance-linked pay, Aberdeen’s incentive structure and general approach to investing has served investors well going on 30 years now.

Board Of Directors

The board comprises five members, with an average tenure approaching four years. John Scott retired as chairman of the trust in May 2012, after 11 years’ service (he was chairman from 2006). He has been succeeded by Rory Macnamara, a non-executive director since 2005. At the start of 2012 they appointed Elisabeth Scott to the board in anticipation of John Scott’s retirement. We think there is a good balance of tenures on the board and the change in chairman has been handled well and ensured consistency for shareholders. Macnamara has seven directorships, of which three are as chairman; Dunedin (DIG) is the only listed investment company’s board on which he sits. Two board members serve on the boards of other listed investment companies and four of the five are shareholders in DIG. All five board members are deemed to be independent. The board meets formally no less than five times each year.

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