BlackRock Income & Growth

BlackRock Income & Growth (BRIG) targets growth in both income and capital over the long term. BRIG has been run by the well-resourced UK Income team at BlackRock since 2012.

Whilst there is significant overlap between BRIG and its better-known open-ended counterpart, the managers Adam Avigdori and David Goldman are keen to use the advantages of the closed-end structure for the trust. This includes the ability to incorporate smaller less liquid companies, and a lesser requirement to consider short-term underlying income generation.

As discussed under Portfolio, the managers tend to place stocks into one of three ‘buckets’. The trust structure, and this approach, allows them to invest in lower yielding names – which they believe to have significant growth or turnaround potential – and focus primarily on generating income growth rather than a high yield. The managers report that they see significant opportunities in the UK market currently.

BRIG has a historic yield of c. 3.8% (as at 25/11/2020). The board has remained supportive of growing the trust’s dividend, which has risen every financial year since 2012. As discussed under Dividend, the board has historically looked to accrue additional revenue reserves in benign conditions whilst distributing these reserves in more challenging environments. As a result, BRIG has strong revenue reserves which could be deployed to help support dividends in the current challenging backdrop. The managers note that their underlying dividend generation has been substantially more resilient than the market.

As discussed under Gearing and Performance, the managers tactically reduced gearing and derisked BRIG at the start of 2020 over concerns about market sentiment. They have subsequently started to increase gearing again. The Discount has again widened in recent weeks to levels wide relative to its own history (c. 8.3% as at 18/12/2020).

BRIG currently holds substantial revenue reserves. The COVID-19 pandemic and the lockdowns that followed have clearly proven a substantial challenge to dividend generation globally, as a vast swathe of companies found their operations either impeded or forced to stop entirely. Secondary impacts to resources demand (energy) and interest rates (banks and insurers) further affected many significant contributors to UK dividends. Whilst there are signs that impairments may not be as substantial or permanent as first feared, the revenue reserves BRIG boasts and previous willingness of the board to deploy them make this, in our view, an attractive source of income for investors looking for a degree of assurance around continued income growth. The managers’ comments on the relative resilience of BRIG’s underlying revenue generation over this period offers further comfort.

With a reserve buffer and the support of the board, BRIG’s managers have retained flexibility to access the best opportunities from a total return perspective. Given the recent bifurcation in UK equity markets, and the significant valuation opportunity which seemingly exists in the UK market writ-large compared to global peers, greater flexibility to invest where the managers identify the best opportunities could be more important than ever in the coming months. Short-term fluctuations in line with wider sentiment towards the UK remain likely, and could especially have a follow-through to discount volatility. However, the managers retain further gearing capacity to take advantage of any market falls.

BlackRock Income & Growth (BRIG) has twin aims of providing growth in both capital and income over the long term. The managers, Adam Avigdori and David Goldman, aim to achieve this through investment primarily in UK listed companies. Adam and David look to construct a high-conviction portfolio of around 40 companies, utilising the insights and processes of the similar BlackRock UK Income open-ended fund, for which they are also part of the management team.

Whilst BlackRock also operate a well-known OEIC product investing on a similar basis (and whilst there is significant crossover between the two products), Adam and David remain keen to utilise the advantages of the closed-ended structure to their advantage when constructing BRIG’s portfolio. With BRIG operating a closed-ended capital structure, the managers have greater ability to allocate a greater proportion of their assets to small and mid-cap opportunities with less concern for potential underlying liquidity concerns.

Source: BlackRock, as at 31/10/2020

The investment trust structure also enables the board to retain a proportion of earnings from dividends in more bountiful years to offset more barren years. This, by extension, affords Adam and David greater flexibility to invest BRIG into opportunities they believe offer the greatest total return potential, whether this be from income or capital growth.

Adam and David look to construct BRIG’s portfolio through a process which sees BRIG take exposure to three different kinds of shares:

• Income Generators: these companies will typically represent between 60-80% of the portfolio (currently c. 71% of net assets as at 31/10/2020).
• Structural Growth Companies: these companies will generally comprise between 15-25% of the portfolio (currently c. 26% of net assets).
• Turnarounds: a maximum of 10% of the portfolio will be invested in these companies. This is an internal hard limit applied by BlackRock that the team will not exceed. (At present they have c. 9% of net assets invested in stocks meeting this classification).

Stock analysis itself is primarily a consideration of bottom-up analysis, assessing company fundamentals. Adam and David, as well as conducting their own research, are able to draw upon the extensive quantitative and qualitative internal analytical resources of BlackRock, as well as accessing external broker research.

Although the sizeable revenue reserves, discussed under Dividends, continue to afford the managers a degree of flexibility in their stock selection with regards income generation, a majority of the portfolio remains invested in ‘Income Generators’. This is, as noted above, in line with what should typically be expected. These companies typically operate in industries with high barriers to entry, and display revenue streams relatively resilient to fluctuations in the economic cycle. Adam and David look for management teams exhibiting evidence of the ability to allocate capital well, and companies which have sufficient free cash flow to afford the necessary research & development to maintain competitive advantages. The managers note that the strengths of these companies are often generally acknowledged by the wider market (with an associated read through to current stock valuations). However, they contend that the ability of companies to leverage these strengths into future growth through compounding of cash flow growth is often underestimated, and that near-term stock valuation models often fail to capture this.

RELX is a good example of this, as a global provider of information-based analytics and decision tools for professional and business customers. The company has been on a journey allocating capital away from print to investing in its risk solutions business, as well as digitalising; monetising the data and analytics it provides. The managers see this transition as having the potential for exciting, long-term growth. The business uses its cash flows to fund its journey but also to enhance shareholder returns through dividends and buybacks.

Given the strong emphasis placed upon the efficiency of capital allocation by the managers of BRIG, they understandably place an emphasis on meeting company management and understanding their strategic outlook for the business. Regular company meetings are thus considered a key input to understanding the ongoing operational performance and outlook of a company, with the BlackRock UK equities team conducting over 1,000 meetings in an ordinary calendar year. Despite disruptions to ordinary meetings procedures in the wake of the COVID-19 pandemic, the management team note they have been able to maintain (and actually considerably increase) the number of meetings they undertake, albeit conducting these remotely.

Adam and David continue to conduct ongoing risk analysis on all positions and the output effect on the total portfolio, including scenario analysis on different market and macroeconomic outcomes. Regular stress tests against a variety of different outcomes (such as changes in interest rates or moves in the FX rate) are conducted. This risk analysis is primarily undertaken to try and understand the portfolio’s exposure to different investment style factors and economic variables, with the aim of ensuring that BRIG is not overly skewed towards any one factor or outcome at any one time. The managers thus hope to ensure that stock-specific factors are the primary driver of their returns relative to the broader market.

As we discuss under Performance, the managers seem to have been largely successful in mitigating the impact of style factors as the drivers of relative returns. However, it is notable that BRIG’s rolling 12-month NAV returns in recent months have displayed closer correlation to those of a UK ‘quality’ index (with a 12-month R2 of 0.98 on a monthly return series). This has been an output of the investment process and the managers’ recognition of broader economic conditions and their impact on operating conditions for companies, as well as the elevated bid activity for stocks displaying factor characteristics.

In the wake of the COVID-19 pandemic, markets increasingly bifurcated between those deemed at heightened risk of insolvency and those perceived as robust to the ongoing economic contraction (or even likely to thrive). Adam and David had, in any event, been derisking BRIG’s portfolio from January onwards through de-gearing and reducing exposure to cyclicals (such as chemicals, industrials and financials). This was in recognition that stocks had rerated higher over 2019 on anaemic earnings growth, at a rate they deemed excessive and incongruous with wider economic and market conditions. Accordingly, the managers did not believe there was sufficient valuation support for much of the market and looked to derisk the portfolio. As the COVID-19 pandemic developed at the start of 2020, they extended this to looking to reduce their exposure to look-through debt and increased the resilience of look-through revenue generation in the constituent companies.

With the market sell-off accelerating towards the end of February and into March 2020, the managers revisited their trading history from the midst of the 2008-09 financial crisis, looking for insights into positive and negative decisions they had made in the middle of a market panic. This, they note, led them to take a more positive tilt within their range of assumptions on the operational outlook for many companies, but also suggested to them that high volatility drawdowns often feed upon themselves. They looked to take advantage of the dislocation in the market to improve the quality of the portfolio for both dividend and total return opportunities, seeking businesses where liquidity or balance sheet risk was reduced and where the long-term growth opportunities were evident. They also did this, more recently, by expanding the gross exposure through a modest increase in gearing.

Accordingly, there has been some rotational activity amongst the portfolio, even as the top-ten holdings share a significant degree of commonality of names as those that were present a year ago.

Source: BlackRock, as at 31/10/2019 and 31/10/2020

Unsurprisingly, the sell-off has created new opportunities for stock-specific turnaround stories, but also created opportunities to take new positions in structural growth stories. These include companies, such as recent addition Electrocomponents, where the managers believe the COVID-19 pandemic and associated lockdown has increased opportunities for the company. Adam and David believe Electrocomponents can emerge from the crisis with the potential to significantly grow market share into an end market which they anticipate has significant recovery potential itself. The company is also seeing improvements in margins and taking share from other suppliers. It survived the COVID-19 pandemic because the CEO has improved the quality of the business over the last few years, investing in the omnichannel, meaning the business was able to fulfil customer needs and deliver share gains. We anticipate the business will be acquisitive in the years to come to generate organic growth, but there is significant potential for this company to be substantially bigger over the next five years as it gains market shares.

Adam and David’s long-term outlook remains constructive for UK equities. They note that the crisis has served as a necessary ‘reset’ on dividends for large swathes of the UK corporate sector, and that many companies are now better positioned for long-term sustainable dividend growth. Whilst they observe significant opportunities at the stock level, they are wary that this is tempered by an expectation that the near-term outlook likely remains volatile with several potential headwinds to risk assets.

They note that economic activity is once again being impacted by national lockdowns imposed across Europe as well as the UK. However, the development and production of a seemingly workable vaccine should provide the market and particularly the industries hardest hit by COVID-19 hope that there is light at the end of the tunnel, and they think that a return to ‘normal life’ could be within our reach at some point next year. In the meantime, Adam and David anticipate governments and central banks will continue to provide fiscal and monetary support. They would also note that corporate balance sheets have, in some cases, increased their levels of debt to withstand the liquidity shocks. Whilst economies will recover in 2021, some companies’ earnings and cash returns will take longer to recover under the burden of higher levels of borrowing.

From a Brexit perspective, the outlook for the UK remains unclear in their view. As negotiations have been going on for some time, companies have had time to prepare their businesses for a no-deal Brexit and the managers therefore see the impact at an individual company level as relatively muted, and they continue to anticipate seeing strong companies prevail, regardless of the result. However, they also note that UK valuations are extreme and even on an industry-adjusted basis remain at multi decade lows relative to other international markets. Once the market has clarity, Adam and David believe we could see this dispersion narrow, serving as a tailwind to the UK market. Similarly, from a dividend perspective they are viewing the outlook for the UK market with increased optimism, and expect dividends to be more resilient and grow faster in future.

BRIG most recently reported gearing of c. 7% (as of 31/10/2020). The managers have the option to gear up to a maximum of 20% of net assets. We understand the gearing facility in place is a two year £4m revolving credit facility.

The managers ordinarily avoid using gearing for short-term market timing, instead viewing it as a method of enhancing returns over the medium to long term. However, having increased gearing in late 2019, they subsequently reduced it sharply at the start of 2020 over concerns about the broader market backdrop after observing that share prices were improving more rapidly than fundamentals despite significant uncertainties in the global economy. Whilst they remained geared throughout the market drawdown of Q1 2020 this was at a much-reduced rate, and this will have reduced the downside impact felt by gearing. The managers subsequently started to increase gearing again as they perceived an improvement in the opportunity set following the sizeable market drawdown of Q1 2020. As noted under Portfolio, they presently note the confluence of myriad attractive opportunities from a bottom-up perspective with continued risks and uncertainties from a top-down perspective. However, the increase in gearing in recent months is in recognition that the attractions of the former are increasingly outweighing their concerns around the latter.

Given the sharp market volatility seen over much of 2020, we have used monthly reported gearing figures in the chart below, which are drawn from officially confirmed BlackRock factsheet data. Daily gearing data points in March, for example, will likely show elevated application of gearing, but this is in reflection of declining NAVs to a perceived static gearing liability as opposed to being indicative of management decisions around gearing.

Source: Morningstar

Over the 12 months to 25/11/2020, BRIG has seen NAV and share price returns of c. -5.1% and c. -3.5% respectively. This represents outperformance of the Morningstar UK Equity Income peer group, which saw average NAV and share price returns of c. -5.5% and c. -4.4% respectively, and of the benchmark FTSE All-Share index (as represented by the X-Trackers FTSE All-Share ETF), which generated returns of c. -9.6%.

BRIG’s NAV saw a period of sharp outperformance of the peer group from mid-February to late March 2020, thanks to the managers’ decision to derisk the portfolio through a reduction in gearing and tilting away from cyclicals (as discussed under Portfolio). The inherently defensive nature of many of the holdings which could be considered ‘Income Generators’ (with a strong focus on quality and resilience of earnings) has mitigated somewhat against relative returns as the market subsequently recovered. Nonetheless, BRIG has still seen strong positive NAV returns from the market low in an absolute sense, having grown NAV by c. 35.8% since the low on 23/03/2020.

The current management team took over the running of the trust in April 2012. Over the period 01/04/2012 – 26/11/2020 they have outperformed the X-Trackers FTSE All-Share ETF, with NAV and share price returns of c. 75% and c. 88.5% respectively. Over this same period, the X-trackers ETF has returned c. 59.2%. However, BRIG has trailed the Morningstar UK Equity Income sector average returns of c. 104.7% and 96.1% (NAV and share price respectively). We would suggest this underperformance to the peer group average is partially because the investment strategy tends to result in BRIG skewing slightly more towards large caps than many of their peers, with the FTSE 250 having outperformed over the same period. This tendency is not always a significant factor, but it does seem to impact returns at more acute moments of changes in the fortunes of the mid cap index to the All-Share.

We have previously highlighted that the managers are typically averse to taking on exposure to companies with highly cyclical earnings and, by extension, dividends. Given the market conditions seen in recent years, this has unsurprisingly led to the relative performance of BRIG’s NAV displaying an inverted correlation to the relative fortunes of value factors against the benchmark. Whilst Adam and David note that Rio Tinto and BHP, for example, are currently highly attractive due to their ability to sustain free cash flow even on sharply lower spot commodity prices, the general tilt away from value seems likely to persist in our opinion.

Adam and David look to ensure no one style factor has an outsized impact on relative returns. We would comment that this looks largely to have been achieved, but also that they have tilted slightly more towards ‘growth’ factors. In the scatter chart below, we can see the relative 12-month NAV performance of BRIG against the FTSE All-Share, and that of a growth (blue), quality (orange), and value (grey) factor index relative to the same index. A trendline sloping from bottom-left to top-right would indicate positive correlation, whilst from top-left to bottom-right would suggest negative correlation.

Source: Morningstar

Whilst a slightly greater tilt towards growth factors can be observed, the broad range around which this trend is scattered suggests a fairly weak correlation to us, in line with the managers’ stated aim. The broader peer group displays relatively similar characteristics, but with a slight inverted skew towards ‘quality’.

As discussed under Portfolio, over the past 12 months BRIG has seen closer correlation to quality factors than growth or value. We would attribute this to the additional focus the managers had placed on financial strength and resilience of earnings towards the start of 2020, which came as part of a tactical reflection on market outlook as opposed to any sustained style shift.

BRIG currently has a historic yield of c. 3.8% (as at 25/11/2020). Whilst this is lower than the AIC UK Equity Income sector weighted average historic yield of c. 4.4% (Source: AIC), we think the backwards nature of this reading is particularly worthy of attention at this time. BRIG’s focus is on ensuring it has the ability to continue to grow income over the long term while also paying reasonable yields. Historic yields are clearly only a reflection of the past, and very substantial dividend cuts have already been seen in the UK market with further cuts anticipated. Accordingly, we do not think historic yields represent a realistic expectation of incomes likely to be achieved in general.

BlackRock estimate the FTSE All-Share has thus far seen peak to trough declines in dividends of c. 40%. They estimate that BRIG’s peak to trough decline in dividends was c. 30%. Whereas the managers expect around 50% of this 40% decline in dividends in the FTSE All-Share to be permanent, they anticipate impairments to be permanent on less than 10% of their own portfolio (as at 31/10/2020). In many ways, they believe that the ‘dividend reset’ seen in recent months in UK companies will ultimately improve the attractions of the UK as a source of income. They note that many companies which had, in their opinion, overdistributed income in recent years have now reset their dividends to more realistic levels that allows for greater growth potential and resilience going forward.

Against this we can set BRIG’s very substantial revenue reserves. Based on information from BRIG’s interim report (from 30/04/2020), we estimate that, subsequent to the payment of the interim dividend but prior to payment of the final dividend (as yet undeclared), BRIG has revenue reserve cover equivalent to at least c. 1.5x the financial year (FY) 2019 dividend of 7.2p per share. We believe this to be a conservative estimate as we have assumed a drawdown in revenues received of c. 30%, in line with what BRIG’s managers tell us was the peak-to-trough drawdown experienced. With the forthcoming release of the annual results, investors should have a clearer picture on the extent to which revenue reserves will need to be deployed if the board opts to support and grow the dividend.

The board has previously announced its intention to support the dividend going forward using revenue reserves. We believe that, having grown the dividend in every financial year since FY 2012, it is highly likely the board will back up words with actions. The board’s willingness to support dividend growth from BRIG has been apparent in the past when it has opted to grow BRIG’s dividend despite more variable revenue returns (a by-product of the investment flexibility afforded to the management team in the interests of best managing long-term income streams).

As can be seen below, the managers and board have been successful in growing the dividend every year since FY 2012. Since the trust’s FY 2012 the dividend has grown at an annualised rate of c. 4.6% to the end of FY 2019. Over the same periods, revenue returns per share have grown at an annualised rate of c. 7.2%.

The portfolio is co-managed by Adam Avigdori and David Goldman, who lead the UK Income team at BlackRock. Their team is a subset of the UK Equity team, which currently numbers 13 investment professionals. Each of the team members has research responsibilities, with sectors rotated around the team over time. The UK team works closely with the European Equity team, comparing notes, valuations and stock ideas.

The team also runs the open-ended BlackRock UK Income, Blackrock UK Charities, and Blackrock UK Charities ESG funds using the same strategy, overseeing over £1bn in assets in total. Adam has been co-manager of the trust since 2012, and David since July 2017.

BRIG presently trades on a discount of c. 8.1% (as at 18/12/2020). This is notably wider than has been seen on average over the previous five years, where the average discount has been c. 3.2%. However, as we can see in the chart below, this discount has proven relatively volatile thus far in 2020, reflecting wider market conditions.

The board was reasonably active in seeking to manage the discount in the financial year 2020 (ending 31/10/2020), having repurchased into treasury a net c. 446k shares (gross c. 458k). Considering the wide levels reached on the discount in Q1 2020, activity was perhaps slightly more muted than it may have otherwise been earlier in 2020 as a result of sizeable market volatility, which made it hard for the board to ensure they were buying shares at a discount to NAV or issuing at a premium. We can see the breakdown of activity in the table below:

Source: London Stock Exchange

There has, as yet, been no issuance or buyback activity thus far in the current financial year (to 26/22/1010). A sizeable proportion of total issued equity is held in treasury, and the board is likely to seek to issue this if BRIG trades at a premium to NAV for a sustained period.

BRIG has an ongoing charge figure (OCF) of 1.07%, which is greater than the sector average level of c. 0.61% (Source: JPMorgan Cazenove). We would, in part, attribute this to BRIG’s relatively small current size, and if the board was successful in growing the trust would perhaps anticipate this falling. This includes a management fee of 0.6% p.a. of the market capitalisation. There has been no performance fee attached to the trust since 2013. The Key Information Document Reduction in Yield figure is 1.7%, compared to a sector average of 1.21%, although we caution that methodologies vary. Fees are charged 25% to revenues, and 75% to capital.

Adam, David and the wider BlackRock team regard ESG as an important input into their investment process. This is especially the case for the key bucket – ‘Income Generators’ – currently accounting for c. 71% of the portfolio, which has a strong focus on ensuring dividends are sustainable. However, ESG factors are considered for all stocks as Adam and David have a strong belief that companies that promote healthy relationships with all stakeholders are better positioned to create opportunities and mitigate risks to sustain financial returns over the long-term.

This is in line with the broader investment strategy, which seeks to ensure that a company’s growth is sustainable. Assessments of this could be by ensuring that optical growth rates are not the artificial results of indiscriminately buying revenue, but are through either internal operational factors or long-term strategic acquisitions. In regards to internal company culture, Adam and David have noted that a company’s ability to attract and retain talent tends to boost firm productivity.

Governance is also considered important, with the team regularly engaging with companies in its purview; indeed, BlackRock boasts a very large Stewardship team to assist with these engagements. The significant passive business run by BlackRock ensures that they have good access and can bring significant weight to bear on management, and they are keen to ensure that firms are allocating capital efficiently and employing strong accounting practices, amongst other things.

BRIG currently has an ‘average’ score on Morningstar sustainalytics.