Morningstar® CEF Report™

Edinburgh Dragon Trust Plc EFM

Morningstar Analyst Report Fund Report for E0GBR01OME Edinburgh Dragon

by Szymon Idzikowski, 24/07/12

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Morningstar's Take EFM

Morningstar Analyst Rating™

Last Price

301.70

Current Discount

-6.18%

Last Actual NAV

321.56

Latest NAV Date

23/05/2013

Gross Gearing

110

Net Gearing

108

1 Year Z Stat.

0.93

Ongoing Charge (2012)

1.27%

Average Daily Shares Traded (1 Yr)

0.17m

Role in Portfolio

Supporting Player. The fund can be used as a diversification tool for investors who want Asian equity exposure.

Executive Summary

Process: Aberdeen applies a patient, value-based, bottom-up approach.
NAV Performance: The fund has outperformed both its category peers and its index since Aberdeen took over this fund at the end of 2003.
People: Andrew Gillan is part of the seasoned and settled Asian equities team headed by Hugh Young.
Parent: Strategic acquisitions have broadened Aberdeen’s product base but its Asia and GEM funds remain key.
Board: The board comprises six non-executive directors with a good mix of tenures and backgrounds.

Morningstar Opinion

We think Edinburgh Dragon ranks among the best choices for Asian equity exposure.

The named manager here is Andrew Gillian but in reality it’s a team approach, in keeping with all Aberdeen equity funds. Prior to Aberdeen’s involvement, it was run by Jeremy Whitley of Edinburgh Fund Managers. When Aberdeen acquired Edinburgh in late 2003, Whitley joined the Asian equity team and this fund followed suit. This team is well resourced and has depth of experience, not least from its leader Hugh Young. Young cofounded Aberdeen’s Singapore office in 1992 with former colleague Peter Hames. Although Hames’ retirement in June 2010 is a loss, we believe the handover has been smooth and Hames’ duties have been divided amongst the team, some of the senior managers of which have been with Aberdeen for more than 10 years. The team is spread across Singapore, Sydney, Bangkok, Kuala Lumpur, Hong Kong, and Tokyo, which gives them a big advantage, as company meetings play an important role in the process.

The process is one of the attractions here. The team follows a firmwide approach originated by Young in 1985 and which emphasises quality, growing companies that have the right management to deal effectively with that growth. They consider quality companies to have sustainable, competitive business models; strong balance sheets; and high returns on assets and capital. They look for management that carry the right skills to grow a company for the benefit of shareholders and are prepared to be patient and wait for the growth.

Indeed, the fund’s turnover, at less than 10% most years, is one of the lowest we have seen and it helps to keep a lid on costs. Further, that patient approach has proved its effectiveness. Since Aberdeen took charge at the end of 2003, Edinburgh Dragon has returned some 14% and has beaten its Morningstar Asia ex-Japan Equity category average fund by 4 percentage points annualised. The team has also demonstrated well its ability to run the fund with risk kept firmly in check. Despite the use of gearing and a fairly concentrated portfolio, its standard deviation, a statistical measure of risk, is lower than that of the category and the index over one, three, and five years, and since the end of 2003.

Gearing has contributed to strong returns, too, and investors can expect to see it maintained at broadly 12% of total assets. The nature of this gearing changed in 2011, when a multi-currency loan facility was replaced with a convertible unsecured loan stock (CULS). This should help with liquidity of the trust’s shares, too, as loan stock holders are presented with conversion opportunities until its redemption in 2018.

Overall, we think there’s much to like here: an experienced and well-resourced team with a tried-and-tested process and a strong risk/return profile. The fund receives our Gold rating.

Portfolio Process Approach

The fund has followed Aberdeen’s tried-and-tested global investment process, established in 1985 by Young and Hames, since coming into the Aberdeen stable in late 2003. The team members invest in quality companies that they understand, that are growing, and that have the management skill to deal with that growth. They consider quality companies to have sustainable, competitive business models; strong balance sheets; and high returns on assets and capital. They like companies that generate significant levels of cash and spend that cash wisely in value-accretive projects or return it to shareholders to make more efficient use of their balance sheet. Management is scrutinised closely to ensure they are trustworthy, capable, and have the right attitude toward corporate governance and plans for the business. Aberdeen’s team members emphasise that they are cautious by nature, and they consider risk from the perspective of avoiding investing in poor-quality companies or overpaying, more so than benchmark risk or tracking error. No company is purchased without the Aberdeen managers first meeting its management. Once the stock passes the quality screen, it is assessed according to a strict valuation process based on ratios such as price/earnings and price/cash flow. The final portfolio is the result of the best ideas of the local teams. Turnover is generally extremely low at 10%-20% as all stocks in the portfolio tend to be long-term holdings.

Portfolio Positioning

The fund is unconstrained, which can lead to the portfolio looking out of step with its peers at times. For example, as at 29 Feb the fund was overweight real estate and underweight consumer cyclicals by almost 7 percentage points in both cases, relative to its Morningstar Asia ex-Japan Equity category average peer. However, this was a function of a bottom-up stock selection, rather than sector calls. Like all Aberdeen funds, the portfolio is fairly concentrated, with holdings ranging between 40 and 60 names, and individual positions tend to be kept below 5%. Turnover is so low at this fund that overall positioning changes infrequently, market moves aside. There is little in the way of Chinese exposure as the companies aren’t of sufficiently high quality in the team’s view; thus, the fund was very underweight here relative to the average peer, by some 20 percentage points. Conversely, the fund was overweight in Hong Kong, India, and Singapore.

Dividends

The primary aim of the fund is to produce capital growth and there is no formal income target. The board does pay a dividend each year, but the amount can vary considerably from one year to the next and cannot be relied on by shareholders as a sustainable source of income in their portfolios.

Discount

The board does not enforce a strict discount control mechanism but they have shareholder approval to buy back shares in the market and they do so periodically at their discretion. In 2010 the board made a tender offer for up to 15% of the fund's ordinary shares at NAV and this was taken up in full. The fund currently trades at a discount to its NAV of around 9% (4 July) compared with its three-year average of 8.3%. This is in keeping with its investment trust peers in the same category, although it's a little wider than other Aberdeen Asian funds.

NAV Performance Analysis

Since 31 Dec 2003, when the Aberdeen Asia Pacific team took over the management of this fund, Edinburgh Dragon has returned over 14% annualised, some 4 percentage points more than its average Morningstar Asia ex-Japan Equity peer. Its particular strength has been to limit losses in down years without broadly compromising too heavily in up years. A good example of this was in 2011, when the fund ended the year down 14%; while any loss is painful for shareholders, the average category fund fared worse, with a loss of 19%. 2008 was a similar story. Conversely, in 2009, the fund picked up as the market rallied and finished the year up around 50%, compared with the average category fund’s 52% gain. The fund tends to underperform peers when poorer-quality names lead markets higher—such as in 2007.

Risk & Return

The fund is fairly concentrated and typically holds some 40 to 60 stocks; the top 10 holdings accounted for 39% of the portfolio at 31 May. Nevertheless, its standard deviation (a statistical measure of risk) is a couple of percentage points lower than that of the category and the benchmark index over one, three, and five years, and since Aberdeen took over as fund manager. That’s a reflection of the team’s emphasis on long-term quality combined with their low-turnover approach, and it has served shareholders well. Turnover here is one of the lowest we’ve seen, at around 10% per annum.

Fees

Aberdeen takes an annual management fee of 1%, half of which is taken from capital and half from income. There is no performance fee levied here. The Ongoing Charges are 1.61%, which compares with its Morningstar Asia ex-Japan Equity category median fund’s TER of 1.89%. While not cheap, it’s competitive among its peers.

Gearing

The manager is permitted by the board to have exposure up to 120% of net assets. In normal market conditions, however, gearing tends to hover around 112%; this level is relatively fixed as a result of the nature of the gearing, which changed in 2011. Previously it was achieved through a GBP 40 million multi-currency loan facility, but in Jan 2011 the board issued GBP 60 million nominal of 3.5% convertible unsecured loan stock, which carries a redemption date of 2018; within that period, holders of CULS may convert their holdings into ordinary shares, which could help provide liquidity for the fund’s shares. The team views gearing as strategic rather than tactical and runs the portfolio fully invested, rather than using cash to offset this gearing.

People

Andrew Gillan is a named fund manager, but in practice the fund has been run on a team basis since the acquisition of Edinburgh Fund Managers by Aberdeen at the end of 2003. Previous manager Jeremy Whitley joined the Asian team at Aberdeen and is still at the firm today. The Asia Pacific fund management team is headed by Hugh Young, who joined Aberdeen in 1985 to manage Asian equities from London; in 1992 he cofounded Singapore-based Aberdeen Asia with Peter Hames. In July 2010 after the retirement of Peter Hames, he was promoted to head Aberdeen Asset Management’s Asian equities. Since Jan 2002 he has also been responsible for EMEA and Latin America. Although Singapore is the central hub for Asian equity research, the team has expanded and today there are investment specialists based in Tokyo, Sydney, Bangkok, Hong Kong, and Kuala Lumpur, all of whom contribute stock ideas. Many team members have been with Aberdeen for nearly 10 years and have amassed considerable expertise in Asian stocks. Analysts are hired early in their career and trained comprehensively in the group's approach. This helps ensure the group's investment process is applied consistently across all levels. In addition, the team’s location within the region enables it to conduct thousands of company visits per year. They also believe in rotating company visits around the team to stay objective, which is a sensible approach in our opinion.

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 six non-executive directors with an average tenure of more than eight years; the longest-serving member has been here for almost 25 years, but this is balanced by two appointments made within the last two years, which should help to keep ideas fresh. Two directors were in situ at the time of the fund’s transition to Aberdeen at the end of 2003. The acquisition of Edinburgh didn’t prompt a wholesale refresh of the board; rather, it has been a gradual process. This helps to ensure continuity as well as preserve the history and understanding of the fund at a board level. All directors are independent, but only four of them hold shares in the fund, which we think is a little disappointing; we like to see their interests aligned with those of the shareholders through a stake in their fund. We’re pleased to see that the most recent recruits are already shareholders. There is a good mix of backgrounds among board members, spanning industry as well as investment management. Four directors sit on boards of other listed companies, including other investment trusts. The board meets at least five times a year.

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