PETER SPILLER, of the Capital Gearing Trust, is the longest-serving manager of an investment trust in the UK. He has been running this specialist vehicle for 38 years and has no plans to retire any time soon. JONATHAN DAVIS went to talk to him. (First published in December 2018 and not updated).
The first thing to say about Peter Spiller is that while his investment trust is relatively small, with a £265m market capitalisation, and still not widely known, he is far from an obscure figure in industry circles. Having started as a broker at Capel Cure Myers, he soon moved on to the blue-blooded broking firm Cazenove, where he remained a partner until 2000. He took over the running of Capital Gearing in 1982 to take advantage of what he saw as a myriad of discount and arbitrage opportunities in the investment trust sector.
Since then, despite progressively making its investment strategy more conservative in order to align with changing market conditions, the trust has put together a remarkable record of strong performance. The shares have compounded at an annual rate of nearly 15%, comfortably thrashing any relevant index and all other long-lived trusts. Unlike many trusts managed by larger investment groups, for whom the pursuit of scale is increasingly important, for most of its life Capital Gearing has remained small by choice.
With a tight shareholder register, dominated by a relatively small but knowledgeable circle of City insiders, for many years the shares traded at a sizeable premium, reflecting the lack of liquidity – there were rarely any sellers – as well as the trust’s strong performance record. In 2016, however, with one eye on the management succession, and another on wider changes in the trust sector, the board successfully introduced a policy of issuing new shares to meet demand and eliminate the premium. The trust has since increased its issued share capital by 2.2×.
The obvious place to start a conversation with a man who bought his first investment trust shares as a private investor in the early 1970s is to ask how the investment trust sector has changed in the near five decades that he has been following it. One striking feature, he says, is that the aggregate market value of investment trusts back then was twice as large as the unit trust (open-ended) sector. Today, it is only a quarter the size of the open-ended equivalent.
The difference in the growth rate he attributes in part to the “blatant bribery that open-ended funds used to use, getting intermediaries to put their clients into the funds, but it was also in large part because investment trust directors did not really do their job. They regarded their job as to make sure that the trust was honestly run and that it continued in existence, but that was it, more or less, full-stop. Discounts were just seen as a function of supply and demand at the time. Growing the trust was not part of their agenda.”
The active discount controls that are now commonplace were not permitted until new rules came in in 2000, so it is true, Spiller says, “that boards were not, in a position to do the sorts of things they can do now”. In fact he is inclined to be more critical of investment trust boards today for not doing as much with their new powers as they might. “We’ve seen significant progress with a number of trusts buying in stock when the discount’s big, and the more progressive ones going on to a zero discount model, but not everyone is doing as much as they could”.
Spiller is well known as a recent tireless advocate of the zero-discount model, and it is the noticeable trend towards that approach which makes him “much more optimistic now that trusts can grow”. The ability to issue and buy back shares, when combined with “the undoubted fact that investment trusts have done better in performance terms than OEICs”, provides a solid platform for future growth, “even if the advantage over OEICs is diminished because the cost difference has come down a lot”. (This is a reference to the fact that since the Retail Distribution Review in 2013 open-ended funds can no longer include commission to brokers as a direct charge to investors in the funds.)
Spiller takes issue, however, with the argument that platforms such as Hargreaves Lansdown are unable to promote investment trusts heavily because of the illiquidity of many investment company shares. “For trusts with a zero discount model, the liquidity that is relevant is not the liquidity of the trust”, he points out, “it is the liquidity of the underlying securities or assets that they own. That message has not really got across to platforms. It’s a pity.”
The way that Spiller has invested Capital Gearing’s assets has changed dramatically since he started out. Along with some core larger holdings, part of the portfolio has always been committed to exploiting small but profitable anomalies in the way that the shares of listed investment trusts are priced in the market, drawing on his long experience and encyclopaedic knowledge of the sector. He was one of the first to appreciate, for example, that there was a turn to be made by anticipating the market’s reaction to investment companies being promoted or relegated from market indices. (There were two trusts in the FTSE 100 index and more than 50 in the FTSE 250 index, as at 1 October 2018.)
Opportunism was a factor behind Capital Gearing’s formation and there are still a number of ‘special situations’ that the trust seeks to exploit to boost its return. The portfolio includes a number of holdings in obscure trusts that most investors have never heard of, but which may for whatever reason, Spiller and his colleagues believe, be trading at the wrong price. Trust enthusiasts like nothing better than spotting obscure opportunities to profit from movements in discounts. Those opportunities are not, however, as common or as large as they once were.
“When we started there was deep pessimism in the financial markets because equities had behaved so badly, and bonds had behaved so badly for such a long time that it created tremendous opportunities in investment trusts. Why? Because that pessimism was expressed in large discounts. There were scores of trusts trading on discounts of more than 20%. Not only that, but pessimism was also expressed through the market’s reaction to gearing of any kind. Gearing was viewed as obviously enhancing risk, which it does. That meant, however, that one of the instruments which worked very well for us in the early days was capital shares. Capital shares have inherent gearing and largely for that reason, they stood at very, very big discounts – in other words at very attractive valuations.
“I remember doing the calculations. They weren’t very difficult calculations, but this was long before computers. We were able to buy capital shares where the return would still be adequate even if the real value of equities were to fall by 10 or 20%. The great advantage of gearing then was that at that stage the real value of the debt was going down by about 7% every year. The dynamics of how that worked was deeply misunderstood by the markets”. [Editor’s note: capital shares were one of the different share classes that investment trusts issued in order to cater for different investor requirements before the split capital trust scandal largely consigned such structures to oblivion.]
The proportion of the trust’s assets committed to equity investments is very different today. When Spiller took over running the trust, back in the 1980s, almost the entire portfolio was in equities of one kind or another. Now the equivalent figure is no more than 25%. The percentage has been falling steadily for many years. Instead the portfolio is dominated today by cash and cash equivalents and, notably, sizeable holdings of US index-linked Treasuries (known as TIPS for short).
This radical change in exposure is primarily down to two factors – the state of the market and the risk tolerance of the trust’s conservative shareholder base, of whom Spiller himself remains a significant member (his 4.7% shareholding is worth some £12.5 million). “Although the trust has evolved in the way it invests, it has always reflected my idea of the portfolio that an investor who has a long-term view, is risk-averse, and doesn’t like drawdowns, should own. You can’t not have drawdowns in the short term, but over time preservation of capital is what matters for this type of investor.”
These days Capital Gearing is happy to be classified as an absolute return fund, aiming to make money in all kinds of market conditions. The current ultra-conservative asset allocation is also driven by Spiller’s view that valuations of nearly all kinds of financial asset are very high and future returns likely to be poor as a result. “We work on the principle that when the outlook for returns is poor and the risk is high, you want very short duration in your portfolio. Back in 1982, prospective returns were very high, and the valuation model that we use now shows that you should have made something like a 16% per annum real return over the next seven years. Actually we did a bit better than that, but when valuations are that low, risk is also low and it is important to take advantage of that combination.”
But what the model also indicates is that “if you want to have great long-term returns, you need to shift your assets around so that you’re exposed to long-duration assets when they’re very cheap and risk is low, and the reverse when they are not”. Back in 1982, the values were “so fabulous that essentially the only thing you had to own was equities, because they’ve got the longest duration of all the main asset classes. Bonds were pretty good too back then, and they produced great returns, but equities were where the real value was”.
Looking back, Spiller adds, “we were also helped in coming to that conclusion by the fact that the tax system in those days was extremely unhelpful to returns that came in the form of income”. The tax system, fortuitously as it turned out, reinforced the decision to go for longer-duration equities. “It’s difficult to recall how high taxes were then, even under Tory governments.” In fact, he says, “it is just mind-blowing to think how poor we were!”
“When I started, nobody cared what they were paid because the top rate of tax on income – the rate at which dividends were taxed – was 98%. What people cared about were their perks, such as their free car, their free petrol, their free gardener, whatever. Everyone had much better cars than their overall economic situation justified, as everything was hugely distorted. It’s wonderful that all that has evaporated.”
But what we have now instead is just as dispiriting as far as future returns are concerned, he believes. In contrast to the 1980s, when equities were dirt cheap, on the same valuation model the prospective longer-term real yield from equities today is “effectively zero”. Not only are earnings multiples sky high, but the prices of all financial assets have been heavily distorted by quantitative easing and other central bank policies since the great financial crisis.
“QE has been very powerful in a number of respects. It has served to distort both the real economy and the price of all financial assets. The price of houses is distorted, the price of equity is distorted, the price of bonds is distorted – everything is distorted. I think that the central banks now have a tiger by the tail. So the Bank of England says it would like to raise shorter interest rates, which is fine, but it knows it can only do it by very small amounts by historic standards, because anything more will have such a devastating effect on the mortgage market that it just can’t be allowed to happen.”
He mentions Andrew Sentence, the economist and former Monetary Policy Committee member who has been on the hawkish tack on interest rates for a long time. “He has been saying that interest rates would need to go up gradually to something like 3 or 4%. In my view, they simply can’t do that. They absolutely can’t. And the worry has to be that if inflation does accelerate, it will be very difficult to stop it, because there is no strategy for controlling inflation which doesn’t involve short-term interest rates going up.”
That really has quite alarming implications, and “makes the prospect of a Corbyn government really frightening. If we also have to throw in fiscal incontinence from Mr McDonnell [Labour’s shadow chancellor], the central bank is not at all well-placed to do anything about it. It’s very far from certain that we’re going to get a Labour government, but I think it might be very alarming if it happened. If confidence were undermined and we had capital flight, there would be concerning consequences for UK financial markets”.
Mapping Capital Gearing’s asset allocation demonstrates how its portfolio has continued to evolve in response to trends in valuations and market dynamics. “By the time we got to the turn of the century, equities were looking pretty rich and we thought that their prospective returns would be quite poor. But bonds still had very good prospective returns at that stage and so we had a much more bond-orientated portfolio. We had long bonds, 30-year bonds. The volatility was not hugely different from equities, but there was much better underlying value. That worked extremely well.”
“If we fast-forward to today, because of the distortions caused largely by QE, the prospective returns on all financial assets are extremely poor. You should not be worrying about the prospective return on equities: the outlook for bonds is much worse! With the exception of TIPS, which we think remain very interesting, we are looking at a prospective return on bonds which is so bad that it is off the page by historical standards.”
It is unlikely however, he says, that the trust would ever go back to the kind of portfolio it had in 1982, even if valuations were as appealing as they were then. Why? “Because in many other respects the world has become an easier place to invest, at least as we speak at the moment. There are no exchange controls, and taxes are much more reasonable. All this might change, of course, but under current circumstances, even if we went back to 1982 values, we might still have more of a spread of assets than we did then. We were 100% in equities then. We’d probably go to a maximum of 80% today.”
One reason for that is there are newer instruments investors can now use to achieve their objectives. Spiller mentions exchange-traded funds (ETFs), low-cost passive securities that can replicate almost any style or regional exposure you can imagine, as the prime example. “We have instruments available to us now, like ETFs, that we did not then. Did you see that Fidelity recently came out with a fee-free ETF? ETFs have made investment in some ways much easier, much cheaper and much more efficient than it was before.”
But aren’t there hidden risks in ETFs, primarily liquidity issues, that investors may not fully appreciate? Spiller does not dissent, but says perspective is needed. One of the reasons that ETFs have been able to flourish is that they are such an easy way to pursue a momentum strategy – that is, buying sectors or styles that have been performing well. “Momentum is a factor that has worked really well over the last 20 years – much to my chagrin, really, as I’m a sort of fundamentalist. More and more money is in that strategy, including from hedge funds, and a lot of it is expressed through ETFs.”
What Spiller worries about is that when momentum does turn negative again, as one day it will, it will make the downward moves even bigger and faster. “After all an ETF just owns what it’s supposed to own, and if some of those are very illiquid, it’s going to be problematic if they get redemptions. So I do worry that ETFs in high-yield bonds, for example, will find that there is really no buyer of some of the things they want to sell, especially in circumstances where people start to get frightened about credit quality.”
Liquidity is a bigger issue in general than it was, he concedes, in part because of regulatory changes, and that was highlighted when a lot of open-ended property funds had to stop dealings after the shock of the Brexit referendum vote. But the risk needs to be kept in perspective. “The residual risk is not extreme, on our analysis. To be honest, I’d be quite surprised if it turned out to be a significant problem. It depends on the instrument of course, but if it’s something like a Spider [the nickname of the massive ETF that tracks the S&P 500 index] I think the liquidity issues are exaggerated. The big ETFs are collateralised. There are a lot of risks in life and the more you know, the more you appreciate how many other risks there are. You just have to rate and size them properly, make sure you’re not over exposed to the wrong ones. I don’t think the potential illiquidity of ETFs is a big one.”
The bond market is a much bigger concern, in Spiller’s view. Real (inflation-adjusted) yields have come down so far that in the UK index-linked gilts have been trading on negative yields for several years. “I think I’m right in saying that real yields in the UK were around 4.5% in the 1980s, or were thereabouts in the early days of index-linked. Today, they’re -1.5%. The market has gone completely mad!” Spiller blames “these crazy yields” on actuaries, who have “persuaded (or rather mandated) pension funds to buy them in order to match their liabilities”.
“Of course, if you don’t care about the health of the sponsor [the company whose employees the pension fund exists to benefit], and the pension fund is fully funded, buying index-linked on a negative yield makes perfect sense. I emphasise not caring about the sponsor, because in every other respect it’s plain mad to invest long term at these negative real rates. If you invest in the long index-linked gilt, even assuming no costs and no taxes, what do you need to pay now to get a guaranteed inflation-proofed £1 to spend in 50 years’ time? When I did the sums recently, you needed to spend £2.10! It’s just unbelievable.”
We move on from such absurdities to discuss the rise of alternative asset trusts, the biggest growth engine in the trust market. “It’s something of an accident that they’re called investment trusts,” Spiller says. “The structure happens to suit, but they’re very different kinds of assets. Many of them are completely illiquid. But I do think they give access to assets that are helpful for investors. We own a fair number. It’s good that you can invest in green infrastructure, solar power or whatever, and they do offer streams of income that look pretty secure. They may not be in the case of the renewables. It depends on the power price, on which we have our own views, but that doesn’t matter. It’s still a valid instrument for investors.”
“Yes, on the whole, I’m pretty positive about infrastructure of one kind or another. Of others that you might think of as alternatives, one that has been very kind to us, and is completely new, has been the ability to buy residential property in Germany. They’re equities. So they’re not going to be immune from moves in the equity markets, but they’re probably a pretty low beta security. They have been terrific. It’s wonderful that as investment trust investors we have these extra clubs in the bag.”
They also have the attraction, he adds, of allowing you to benefit from the distortions in the price of money. “There is an interesting parallel with 1982, when gearing worked because the value of your debt in real terms was falling rapidly. Today, there isn’t rapid inflation, but we have the wonderful example of a well-known public company whose commercial paper has traded at negative yields. Effectively someone is paying them to finance their buildings!
“Just in the same way that investment trust analysts mark debt to market, I think when you’re looking at the asset value of these companies, we can attribute some value to the fact that they can finance at extraordinarily low rates. That doesn’t mean to say they should be highly geared. Obviously you have to have assets that you have confidence will hold that real value, or something close to it, but there’s a value there that is underappreciated.”
Is it not the case, I say, that the risks of some of the alternative asset trusts may be subtly increasing over time? Spiller agrees. “I think there’s an issue for most of these alternatives in that there is a limited supply. What we observe, as in all history, when you’ve got something that works, but the managers want to get bigger, they go and buy (say) something overseas which they know less about, or they buy newer assets. If you take wind farm or solar, for example, each new generation of investments has less secure income than the past. For the substantial majority of the earlier ones the subsidy was fixed, but now it is not.”
“There’s absolutely no doubt that the quality of earnings deteriorates from both those things. None of that makes them uninteresting investments, but it’s a trend one needs to be aware of. The reality is that the opportunities change all the time. The opportunities were fabulous in investment trusts in 1982, they’re much less interesting now as a general statement than they were then, but all sorts of other things have come up. I think on the whole I’m enthusiastic that the market has gone into these new asset classes. The fees are a bit high, but they will come down in time.”
In the meantime Capital Gearing continues to hunker down in preparation for a less fertile time for investors. Spiller sums up his argument for caution. “Inflation is very low, but we think it will rise. Interest rates are very low; we probably think they will rise too. The P/E ratio is high and it’s going to fall – that is not unrelated to the previous two points of course – and balance sheets are extremely ropy. It’s also fair to say that as a general statement business in most of the Western world is extremely highly geared.
“In those circumstances, the concern has to be not just that the valuations change for the worse, but that the structure is very fragile and correcting it will destroy a lot of value – although destroy it and then put it together again. That is how markets historically perform. They are cyclical, and prone to boom and bust”.
So, I say, could this be a test of capitalism itself, as there was in the 1970s too?
“I do believe that capitalism itself has gone down a route which it needs to come back from. I am referring to the whole concept that the only thing that matters is shareholder value, clients are there to be exploited and the short term is far more important than the long term. All this has reduced the quality of earnings that companies make. It’s very difficult to quantify, but if you’re running a utility in the UK, to take an example, you’ve got earnings which have been achieved by deliberately obscuring prices.
“Essentially, there is an adversarial relationship with their clients, which has made them very unpopular. So, it is not surprising that when politicians talk about nationalisation, that resonates with their supporters. I do think these things have long-term consequences. That the quality of earnings is lower than it was is just one example, and that is quite apart from the accounting which itself has considerably exaggerated the declared earnings of companies. Most of the differences when you look at them in detail are absolutely indefensible.”
Thank goodness, then, for the security of TIPS, which as I mentioned earlier make up a striking 25% of the Capital Gearing portfolio. It is not easy for UK investors to buy them directly, which is one reason why Spiller’s team at CG Asset Management also run funds for institutional investors that exclusively invest in these instruments. Why does he think they are such a better safe haven than their crazily priced UK equivalent, index-linked gilts? “TIPS are a much better instrument because in America, almost the exact opposite pressure prevails, I think. Most pension funds in America, particularly the public ones, have an assumed rate of return of 7 to 8%. That looks and is ludicrous”.
“But one thing it means is that if you’re running a pension fund in America, the last thing you can buy is TIPS. Because unless inflation is 7% per annum, it is simply impossible to meet your target return by buying them. As a result, the pension funds, which are the natural buyers of index-linked government bonds, are effectively prevented from buying them! The good news is that as a result the TIPS market is throwing up much better value. The real yield is a positive 1.05%, compared to a negative 1.5% in the UK. We have 25% of the assets in TIPS. Obviously, in the short term, the currency is a source of volatility, but we like the protection that they provide from the particular risks that the UK faces. Definitely there’s some risk there, but if what you’re trying to do is preserve your standard of living over the long term, as we are, then we think this is the safest place to shelter.”
Mind you, it is fair to say that Spiller has been in defensive mode for some time. Among other concerns, he remains deeply unconvinced about the viability of the euro and the whole European project. Given its defensive positioning, returns from Capital Gearing shares have inevitably lagged a long way behind those he achieved in the very different market conditions of its early life. But he has no plans to quit. “By far the most significant move that I’ve made recently has been to bring together a team that are 25 to 30 years younger than me. We work closely together and have done, in the case of most of the team, for eight years now. Hopefully I’ve got another five or six years to go, at least. When I retire, it means that the culture will not change, even though inevitably the investments will.” For that to happen, all he needs is for markets to come off their unsustainable highs. Patience remains the watchword.
PETER SPILLER founded CG Asset Management (cgasset.com) in 2000 and has been the lead manager of Capital Gearing Trust since 1982. He was previously a partner at Cazenove & Co Capital Management.