EDINBURGH INVESTMENT TRUST PLC - Half-year Report

1.             an increase of the Net Asset Value per share in excess of the growth in the FTSE All-Share Index; and

2.             growth in dividends per share in excess of the rate of UK inflation.

Performance Statistics

Notes: 1.   Source: Thomson Reuters Datastream.

     2.  Gross gearing: borrowings (at par) ÷ shareholders’ funds.

     3.  Net gearing: borrowings (at par) less cash and cash equivalents ÷ shareholders’ funds.

     4.  Dividends declared in respect of the financial year.

INTERIM MANAGEMENT REPORT INCORPORATING THE CHAIRMAN’S STATEMENT

Dear Shareholder,

These six month results are reported against a backdrop of the EU referendum and the (then) upcoming US presidential election. The consequences, whether favourable or unfavourable, are likely to dominate the political and economic landscape for some years to come.

The UK equity market, after an initial fall following the surprise referendum result, rallied strongly and both the FTSE 100 index (benefiting from weak sterling) and the more domestically oriented FTSE 250 index recovered strongly to reach all time highs. Good index returns, however, mask some radical disparities in sector performance and our portfolio, whilst recording positive returns, lagged the benchmark index due in large part to strong performance in some stocks and sectors we do not hold. Further details and commentary are contained in the Manager’s Report which follows.

Our portfolio manager Mark Barnett, with an unchanged strategy, continues to focus on long term performance. I am pleased to report that James Goldstone, who has been working in the Manager’s UK equity team for the last four years, has been appointed deputy manager of the Company’s portfolio to work alongside Mark.

Performance

The Company produced a positive net asset value (NAV) total return for the six months to 30 September 2016 of 6.8% (debt at par) and 6.6% (debt at market), compared to a return of 12.9% by the FTSE All-Share Index, the Company’s benchmark. The share price total return (share price with dividends reinvested) for the period was 11.1%, with the Company’s share price ending the period at 724.0p, an increase of 8.9% from the year end share price of 665.0p.

The demand for shares in the market resulted in the discount (with NAV at par) of the Company narrowing from 6.4% at the year end to 2.5% on 30 September 2016. With debt at market value, the shares at this time were trading at a discount of 0.2% (31 March 2016: 4.4%). At 21 November 2016, the latest practical date prior to signing this report, the share price of 699.5p was at a 0.4% discount to the NAV (debt at market value) of 702.3p and a 2.6% discount to the NAV (debt at par) of 717.9p.

The portfolio continues to be concentrated in a relatively small number of sectors and its overweight or underweight positions in various sectors can be material drivers of the Company’s relative investment performance.

Dividend

As in previous years, the Board continues the exercise to rebalance the interim and final dividends, whilst simultaneously aiming to at least maintain the final dividend. Consequently, the Board has declared a first interim dividend of 5.4p (2015: 5.2p), an increase of 3.8%. This will be paid on 30 November 2016 to shareholders on the register on 18 November 2016, with shares quoted ex-dividend on 17 November 2016.

The Board, and the portfolio managers, remain cognisant of the Company’s objective to grow the dividend payable to shareholders by more than the rate of UK inflation over the long term.

By this time last year, the Company had earned over £3 million of special dividends which contributed substantially to total dividend income for the six months of £30.3 million. Special dividends by their nature are not recurring, so it should be no surprise that none were earned in the six months being reported. However, partly countering this, dividend income in aggregate benefited from the fall in sterling. I am pleased to report that the portfolio has generated over £30.7 million of dividend income with the result that revenue return per share for the period matches that of the comparable six months to September 2015 of 13.9p.

Borrowings and Gearing

The Company has in place a mixture of fixed and floating rate debt. The former is the Company’s £100 million 7¾% debenture which matures in 2022 and the latter a £150 million, 364 day bank credit facility. By this means, Mark has the ability to vary the gearing level of the portfolio depending on his view of the market. During the period under review aggregate borrowings ranged between £180 million and £228 million, and ended the period at £222.8 million – equivalent to gross gearing of 15.3% (debt at par).

Outlook

The fallout from both the EU referendum result and the US election makes it more difficult than usual to predict future economic and market trends with any confidence. One can comfortably justify caution in relation to UK equities on valuation grounds, albeit that yields are likely to continue to provide support while bonds look even more expensive. The Board remains confident that Mark’s high conviction approach to investment, driven by careful stock selection, is right for such uncertain times. The approach will inevitably lead to portfolio performance that will diverge from that of the index and, as we have seen this half year, may result in periods of underperformance, especially in sharply rising markets. However, the focus as in the past remains on adding significant value over the long term.

Jim Pettigrew
Chairman
23 November 2016

MANAGER’S REPORT

Market Review

After a volatile start to 2016, the UK stock market rose strongly over the six month period to 30 September 2016. This was driven initially by rising commodity prices and “dovish” central bank monetary policy and then, following the Brexit referendum, by the sharp fall in sterling. There was significant divergence in sector performance during the period, with share price falls after the referendum seen most acutely in certain domestically focused sectors whereas the share prices of companies with US dollar denominated earnings rose strongly in anticipation of upgrades to forecast earnings. The resources sectors (oil and mining) performed notably well over the period, as crude oil continued to rise from its February price lows, recently on news that OPEC members had proposed production cuts, and the continued rally in commodity prices buoyed global mining companies.

Alongside the Brexit effect, the UK stock market’s attention remained focused on the timing of the next increase in US interest rates, which was generally perceived as being postponed until December.

Sector volatility moderated towards the period end, with the share prices of domestically focused companies showing some recovery. The Bank of England’s 0.25% cut in interest rates met expectations, but the broader language around monetary stimulus went further than many in the market had anticipated. Economic data provided some more encouraging signs for the UK economy: September’s Purchasing Manager’s Index indicated confidence in British business, with rises in services output and new business following August’s declines.

Portfolio Strategy and Review

The Company’s net asset value, including reinvested dividends, rose by 6.8% (debt at par) and 6.6% (debt at market value) during the period under review, compared with a rise of 12.9% by the FTSE All-Share Index.

Against a strong market backdrop, the Company delivered a positive return, but failed to match the rise of the benchmark index. The Company’s performance was held back by its zero weighting in the mining sector and the absence of a holding in HSBC and Royal Dutch Shell. These share prices rose strongly, benefiting from weakened sterling (which declined by 8.8% against the US dollar over the period) and, in the case of Royal Dutch Shell, from the recovering oil price. The zero weighting in UK domestic banks was, however, beneficial to portfolio performance.

The holdings in the tobacco sector again delivered a positive contribution to performance, helped by their international exposure, but also from continued positive news flow. British American Tobacco is seeing the benefits of its focus on key brands – its Global Drive Brands posted a 10.5% volume increase in its Q2 earnings report. Imperial Brands’ half year results confirmed a 10% interim dividend increase as it reaps further benefits from last year’s acquisition in the US of brands (including Winston) and manufacturing facilities.

AstraZeneca, another US dollar beneficiary, announced plans to file its injectable asthma treatment drug with US and European regulators later this year, after favourable trial results. The failure of Bristol-Myers’ lung cancer study was also seen as positive for AstraZeneca’s combination therapy cancer drugs.

Other significant positive contributions to portfolio performance came from the holdings in BP, Burford Capital, Compass, HomeServe and Rentokil Initial.

The portfolio’s holdings in domestic sectors, notably those particularly exposed to the fall in sterling and perceived challenges to the UK economy, performed poorly in the aftermath of the referendum. The stock market was also inclined to de-rate companies which warned of lower profits – delivering a “double-whammy” impact on the share price via a fall in both earnings forecast and P/E ratios. 

Notable amongst these was the holding in Capita, which fell sharply in value as it downgraded full-year earnings forecasts, blaming a slow-down in specific trading businesses, one-off costs and problems with a major contract with TFL – along with delayed client decision-making since the EU referendum.

The holdings in the travel sector – easyJet and Thomas Cook – warned of the negative impact of weaker sterling and were additionally impacted over the period by concerns over terrorist activity and by air traffic control strikes. There was some respite for Thomas Cook shareholders towards period end as the company confirmed full year profit guidance. The benefits of the measures the company has taken over the past two years are offsetting a challenging trading environment.

Other domestically focused holdings to deliver negative share price performance included Derwent London, N Brown, GAME Digital, BT and TalkTalk Telecom.

The share price of Circassia Pharmaceuticals fell sharply on news that its cat allergy drug had failed to meet the primary end point of Phase III trials. While this was very disappointing and surprising news – the drug had performed well in Phase II trials – it is noteworthy that Circassia Pharmaceuticals retains significant cash on its balance sheet and that, over the past year, the company has also made significant diversification into respiratory drugs, devices and technologies. 

In terms of portfolio activity during the period, new investments were made in Next, Secure Trust Bank and Hadrians Wall Secured Investments. The remaining holding in Reckitt Benckiser was sold.

Outlook

It is likely that the near term outlook for the UK equity market will continue to be dictated by the movement of global bond prices and the sterling/US dollar exchange rate. These asset markets have exerted a major influence on UK equities over the course of 2016. The strong performance of the bond market, not always associated with a rising equity market, and the perceived benefit from the drop in sterling have been the driving forces behind the ongoing re-rating of UK equities to reach a current PE valuation of 17.5x forecast 2016 EPS. This valuation looks full, particularly relative to the disappointing overall level of underlying profit growth recorded this year (excluding the impact of sterling and the commodity bounce back). It is highly unlikely that the re-rating of UK equities will continue unchecked against a backdrop of higher valuations and ongoing pressure on corporate profitability. It is noticeable how the rate of profit warnings across the market has increased in the past few weeks. In addition, the recent reversal of bond markets has put pressure on valuations in certain sectors.

There are several challenges which may force a reassessment of the current valuations that are being applied to the UK equity market. The first is the lack of overall profit growth, which, absent a significant devaluation in sterling, would have seen another year of no growth in 2016. The underlying earnings outlook for next year looks similarly muted. Second, a more difficult near-term UK economic picture is likely to emerge. The reappearance of inflation – largely as a result of the movement in sterling – will pressurise consumer budgets and hinder overall levels of economic growth. This factor, coupled with the ongoing uncertainty over the political path to Brexit, may put a brake on UK employment levels and investment intentions, further moderating activity in the domestic economy. To some extent, this has been priced into equities, as the performance disparity between global and domestic companies since the referendum has been significant. Nevertheless, the backdrop to corporate profitability is unlikely to ease over the coming year as pricing power remains elusive.

The political backdrop has the potential to deliver more surprises over the coming year, a third factor likely to continue to exert major influence on both corporate behaviour and stock market performance. The election of Donald Trump as the next US president has already set off widespread expectations of fiscal reflation with knock-on effects in certain stock market sectors. The domestic political scene is currently overshadowed by the new government’s evolving political agenda, while internationally, there are a series of important elections on the horizon; the potential for a sudden policy shift or unexpected election results is significant.

Finally, a shift in the value of global bonds also has the potential to de-stabilise the outlook for UK equities. This could emanate from US policy tightening or simply a realisation that the extreme low yields reached over the summer months across the world no longer represent a realistic view of the medium term outlook for inflation and interest rates. Indeed, at the time of writing, we are witnessing a meaningful shift upwards in 10 year bond yields.

Navigating any of these obstacles, either individually or in combination, will continue to be challenging. The most important discipline is to remain vigilant about valuation. Notwithstanding the elevated level of stock market valuation, there are bottom-up opportunities for the long-term investor, which have started to emerge as a result of the substantial sector rotations that have occurred since the June referendum. Where new bottom-up opportunities arise, the emphasis will continue to be on companies that can demonstrate a sustainable top line growth and translate that into profit, free cash flow and dividends without excessive financial leverage.

Mark Barnett           James Goldstone
Portfolio Manager     Deputy Portfolio Manager

23 November 2016

Total Returns to 30 September 2016

Source: Thomson Reuters Datastream.

Principal Risks and Uncertainties

The principal risk factors relating to the Company can be summarised as follows:

•     Market Risk – a fall in the stock market as a whole will affect the performance of the portfolio, as well as the performance of individual portfolio investments; it also includes interest rate and currency risks; market risk may be impacted by increased volatility during the period of uncertainty following the EU referendum;

•     Investment Performance Risk – this is the stock specific risk that the stock selection process may not achieve the Company’s published objectives;

•     Gearing and Borrowing Risk – in addition to the debenture in issue, the Company may also borrow money for investment purposes. If the investments fall in value, the gearing will have an adverse impact on performance. If the borrowing facility could not be renewed, the Company might have to sell investments to repay this;

•     Income/Dividend Risk – investment income may fail to reach the level required to meet the Company’s income objective;

•     Share Price Risk – the Company’s prospects and NAV may not be fully reflected in the share price;

•     Control Systems Risk – the Board relies on the effectiveness of the Manager’s control systems which include control activities in fund management operations, financial controls, meeting regulatory requirements and managing relations with third parties;

•     Reliance on Manager and other Third Party Providers Risk – the Company has no employees, so is reliant upon the performance of third party service providers for it to function, particularly the Manager, depositary, custodian and registrar; and

•     Other Risks – the Company may be affected by other risks such as business, cyber security, strategic, policy and political risks, as well as regulatory risks (such as an adverse change in the tax treatment of investment companies) and the perceived impact of the Manager ceasing to be involved with the Company.

A detailed explanation of these principal risks and uncertainties can be found on pages 9 to 12 of the 2016 annual financial report, which is available on the Company’s section of the Manager’s website at www.invescoperpetual.co.uk/edinburgh.

In the view of the Board, these principal risks and uncertainties are substantially unchanged from the previous year end and are as much applicable to the remaining six months of the financial year, as they were to the six months under review. The risk associated with failure of the custodian is mitigated by the appointment of the depositary. The depositary is ultimately responsible for safekeeping of the Company’s custodial assets and is strictly liable for the recovery of these in the event of loss.

As highlighted in the annual financial report, the Manager’s style may result in a concentrated portfolio. In addition, the Manager manages other portfolios holding many of the same stocks as the Company which reflects the Manager’s high conviction style of investment management. This could potentially increase liquidity risk under certain scenarios and market conditions.

Going Concern

These financial statements have been prepared on a going concern basis. The Directors consider this is the appropriate basis as the Company has adequate resources to continue in operational existence for the foreseeable future being at least 12 months after the date of approval of these half year financial statements. In considering this, the Directors took into account the diversified portfolio of readily realisable securities which can be used to meet funding commitments, and the ability of the Company to meet all its liabilities and ongoing expenses from its assets and revenue.

Related Party Transactions

Under UK Generally Accepted Accounting Practice (UK Accounting Standards and applicable law), the Company has identified the Directors as related parties. No other related parties have been identified. No transactions with related parties have taken place which have materially affected the financial position or the performance of the Company.

Directors’ Responsibility Statement

IN RESPECT OF THE PREPARATION OF THE HALF-YEARLY FINANCIAL REPORT

The Directors are responsible for preparing the half-yearly financial report using accounting policies consistent with applicable law and UK Accounting Standards.

The Directors confirm that to the best of their knowledge:

•               the condensed set of financial statements has been prepared in accordance with the FRS 104 Interim Financial Reporting; and

•               the interim management report includes a fair review of the information required by Disclosure Guidance and Transparency Rules (DTR):

(a) DTR 4.2.7R, being an indication of important events that have occurred during the first six months of the financial year and their impact on the condensed set of financial statements; and a description of the principal risks and uncertainties for the remaining six months of the year; and

(b) DTR 4.2.8R, being related party transactions that have taken place in the first six months of the current financial year and that have materially affected the financial position or performance of the Company during that period; and any changes in the related party transactions described in the last annual report that could do so.

Signed on behalf of the Board of Directors.

Jim Pettigrew
Chairman

23 November 2016

INVESTMENTS IN ORDER OF VALUATION
AT 30 SEPTEMBER 2016
UK listed and ordinary shares unless stated otherwise.
^AIM Investments quoted on AIM.

CONDENSED INCOME STATEMENT

The total column of this statement represents the Company’s profit and loss account, prepared in accordance with UK Accounting Standards. The return on ordinary activities after taxation is the total comprehensive income and therefore no additional statement of comprehensive income is presented. The supplementary revenue and capital columns are presented for information purposes in accordance with the Statement of Recommended Practice issued by the Association of Investment Companies. All items in the above statement derive from continuing operations. No operations were acquired or discontinued in the period.

CONDENSED RECONCILIATION OF MOVEMENTS IN SHAREHOLDERS’ FUNDS

CONDENSED BALANCE SHEET
Registered number SC1836

NOTES TO THE CONDENSED FINANCIAL STATEMENTS

1.             Accounting policies

The condensed financial statements have been prepared in accordance with applicable United Kingdom Accounting Standards and applicable law (UK Generally Accepted Accounting Practice), including FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland, FRS 104 Interim Financial Reporting and the Statement of Recommended Practice Financial Statements of Investment Trust Companies and Venture Capital Trusts, issued by the Association of Investment Companies in November 2014. The financial statements are issued on a going concern basis.

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