Ian Cowie: the investment trusts betting heavily on ‘cheap’ British shares

Gearing - or borrowing to buy shares - is a double-edged sword for investors because it can increase losses as well as profits. It all depends on whether the credit costs more or less than returns achieved by the assets being bought.

Never mind the theory, though, now some investment trust managers are cutting through the credit jargon and putting it into practice by betting heavily on British shares. Will investors be winners or losers from rattling up the gearing risk and reward ladder?

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We have all heard how UK Plc has been undervalued in recent years; especially since we left the European Union and the world’s largest free trade zone. Here and now, gearing should give greater gains where optimism is justified - just don’t complain if pessimism proves closer to the truth.

Unlike unit trusts and most other forms of pooled funds, many investment trusts are allowed to use gearing. For example, the average member of the Association of Investment Companies (AIC) has borrowed - or issued bonds to fund investment - equal to about 9% of their underlying assets, but some “UK All Companies” trusts have half as much gearing again.

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Step forward Mercantile Ord (LSE:MRC), a JPMorgan giant which has total assets of £2.3 billion and gearing of 15%. According to independent statisticians Morningstar, MRC achieved total returns of 17%, 27% and 97% over the last year, five years and decade.

For comparison, the same source puts total returns from the “UK All Companies” sector at 12%, 24% and 83%. So MRC’s managers’ willingness to increase risk has helped to increase returns.

Better still, MRC’s modest dividend yield of 3.3% has risen by an annual average of nearly 4% over the last five years. This investment trust can also be seen to have withstood the test of time, having been launched in 1884. Therefore, it survived both world wars and the Great Depression.

However, MRC’s manager, Guy Anderson, remains wary of reasons to worry about the future - including some we can do nothing about. He explained: “As part of a global financial system, the key risks for the UK shares are similar to those faced by other markets.

“Inflation remains stickier than many investors had imagined, and there are questions around when we might see some easing in monetary policy. In addition to broader geopolitical risks, we’ll also see half the world’s population voting in elections this year.”

Shires Income Ord (LSE:SHRS) is another long-established trust currently running 15% geared. Founded in 1929, it has also survived several stock market shocks that finished lesser funds but is much smaller than MRC with total assets of £128 million.

More importantly for shareholders, SHRS also delivered much smaller “returns” of -3.2%, then gains of 12% and 55%. That compares with its sector, “UK Equity Income”, delivering average positive returns of 3.7%, 27% and 75%.

Income seekers can draw some consolation from SHRS’s current dividend yield of 6.2%, which has grown - albeit rather gradually - by an annual average of 1.8% over the past five years.

Cynics may suspect this is another example of the real cost of a high income today turning out to be low or no capital growth tomorrow.

Unsurprisingly, SHRS manager Iain Pyle is more inclined to emphasise the positive, pointing out: “The UK market’s attractive valuation and high yield offer a degree of downside protection.

“A more pressing concern is the possibility of the UK market failing to enhance its relevance, which hinges on attracting companies to list in the UK and on investors allocating capital here. It’s crucial for the UK market to maintain its significance among asset allocators.”

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Let’s hope stock market chatter that the oil giant Shell (LSE:SHEL) might be next to abandon its London Stock Exchange listing - following the recent departures of the plumbing equipment firm Ferguson (NYSE:FERG), the building materials group, CRH (NYSE:CRH) and the semi-conductor chip-maker ARM Holdings ADR (NASDAQ:ARM) - proves unfounded.

If so, that would improve the chances of UK investment trusts’ gearing proving a good move.

Annabel Brodie-Smith, a director of the AIC, said: “Being able to gear is an important advantage of investment trusts, giving them the ability to supercharge returns in rising markets. Higher than average levels of gearing by several UK-focused investment trusts suggests that their managers are optimistic about the future and recent record highs for the FTSE 100 reinforce that optimistic outlook.”

Nobody gets married in the expectation of being divorced, although that is the unhappy ending to many a marital saga. Equally, equity investors always buy in the hope of higher prices ahead. One way or another, gearing gives UK investment trust shareholders “more bang for their bucks” - we just don’t know yet whether that will be in a pleasant or painful way.

Ian Cowie is a freelance contributor and not a direct employee of interactive investor.