Scottish Oriental Smaller Companies

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the region must outstrip that of the developed world over the long term

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Proposition

Scottish Oriental Investment Trust is a thoroughbred Asian smaller-companies trust which has, over a long period, delivered solid returns and a rising dividend with lower volatility than the majority of its peers, trading at or close to a premium for extended periods without extensive buybacks.

The trust has achieved this via a well-documented, team-based investment process, focused on identifying high-quality companies managed by high-high-quality people, while managing risk via the active use of cash, and a risk averse approach to gearing.

The trust has seen considerable flux in terms of management since the departure of Susie Rippinghall, who retired in 2013 after thirteen years on the bridge. Initially Angus Tulloch stepped in, covering for Rippinghall’s successor Wee Li Hee who – by the time Rippinghall left – was on maternity leave.

Wee Hi Lee has been named lead manager of the fund since she returned in July 2014, when Angus stepped back to become co-manager. Since then, however, First State has announced plans to split its Asian business in half – to become First State Stewart (based in Edinburgh) and FSS Asia (based in Hong Kong) – meaning that, this month, Angus Tulloch ended his association with the fund entirely given that it is FSS Asia will run the trust going foward. Wee Li Hee is joined, again, by former co-manager Martin Lau as well as Scott McNab, who has also previously worked on the trust – now both joint heads of FSS Asia – who will support her as lead manager on the fund.

This somewhat Byzantine history puts the spotlight on continuity, but Wee Hi Lee, who joined First State Stewart in Singapore in 2002, has worked closely with Angus Tulloch since 2005 and – along with Lau and McNab with whom she’s worked before – all three were chosen as part of ongoing succession planning around Angus, whose career in the City began in 1980.

The group’s collegiate investment approach remains the same as it was before the split. The whole team are ana-lysts, each with specific responsibility for a core area, and ideas are shared between them. Some, like Wee Hi Lee, have portfolio responsibility and are named managers on individual funds. While they have the autonomy to buy and

2 sell stock at will, when they do so they must detail the trade, and the reasons for it, to the rest of the team.

The trust invests in smaller Asian quoted companies, those with a market cap of less than $1.5bn, seeking sustaina-ble earnings growth at an attractive price. The managers pursue a rigorous investment process, looking for high=quality companies within a macro overlay and identifying those which offer sustainable earnings growth at rea-sonable prices. They target businesses with pricing power and a competitive advantage, with a particular focus on the people who run the show – looking for management teams with proven ability. A clear focus on shareholder friendly companies that can demonstrate free cashflow in their view helps them to avoid accounting scandals. Consumer-led companies dominate the portfolio, which is heavily exposed to "consumer discretionary" – its largest weighting – and "consumer staples". Wee Hi Lee is happy to hold on to a company as it grows and, indeed, the larg-est company in the portfolio is valued at over $17bn and has been a fixture almost since launch. She cannot buy a company back once she’s sold it if it’s beyond the $1.5bn cap.

The trust’s exposure to India has supported its performance in recent years and India remains the largest regional weighting in the portfolio at 21%. China makes up a significant proportion, too, alongside significant weightings in Singapore and Taiwan. Tellingly, cash is one of the trust’s largest holdings at the moment at more than 10%.

The managers have an explicit focus on capital preservation and, while it has the ability to use gearing, they tend to run with net cash position. In keeping with the ‘all-rounder’ feel this trust has, while the board does not set an income target the trust has grown or at least maintained dividends in all financial years bar one since the fund’s inception. Reserves have been developed, too, and the dividend is covered for more than a year and a half at the current level.

3 erage fund in the AIC Asia Pacific ex Japan sector and its open-ended IA equivalent. It has also outperforming the benchmark MSCI Asia Pacific ex Japan index by a wide margin over the last ten years. Given the small-cap focus, the trust’s risk statistics are just as credible: the NAV has a beta of 0.8 over the past 5 years, illustrating the cautious approach from the manager to small-cap stock picking. But perhaps more impressively, the trust’s volatility over five years - 11.5% - is considerably lower than the (large-cap dominated) benchmark volatility of 15.5%, illustrating the cautious approach and we imagine the diversification that the manager has found across holdings.

Annually, the charts below demonstrate the trust’s ability to outperform the peer group in falling markets without necessarily hampering its prospects when markets are rising, a characteristic which was particularly evident in the recoveries of 2009 and 2012.

4 Over the period since Susie Rippinghall left, the trust has had a less remarkable period of performance, with the NAV moving in track with benchmarks and peers alike. We believe that should a more positive outlook appear, the trust will start to deliver once again.

Gearing

The board of SST last year renegotiated the trust’s borrowing facility, putting in place a five-year fixed loan in GBP to replace three-year USD debt. The managers have said they would use this gearing to enhance returns should a significant correction occur, but at present the trust has a net cash position of 7%. The managers, as a consequence of their focus on capital preser-vation, have tended to err on the side of caution since the financial crisis in 2008 and some cash has built up in the portfolio for want of attractive options.

Alignment

The group has a strong focus on locking in its key staff for the long term. 70% of the investment team’s performance bonuses are tied to managers’ three-year numbers, and no bonuses are ever paid on shorter-term performance, while a further 30% is paid on the five year numbers.

Fund managers and analysts at FSS Asia are also tied in to the products which they manage via a profit share which invests into the group’s funds and locks the money in for three years. Any money placed into these schemes in the last three years on their behalf is void if they leave.

Discount

SST has traded at or close to a premium in the past, but has seen its discount widen markedly since the start of the year. There is no active discount management policy in place. The board, though it has the authority to buy back shares, believe that the best way to manage the discount is through good management of the fund and good performance, and has said it would con-sider buying back shares only if the discount extended beyond 15%.

5 The discount currently stands at 11.5%, its widest point for around five years, and this partly reflects the way discounts across the sector have moved. Smaller companies trusts in particular have been hit hard by uncertainty over the outlook for the re-gion.

Conclusion

Asia, in our view, is a vital ingredient for a long-term growth portfolio. The demographics alone mean that growth from the region, regardless of the short-term squabbles which erupt along the way, must outstrip that of the developed world over the long term. Asian smaller companies we think, particularly when linked to the ever-growing consumer, are the best way to har-ness that astonishing potential.

Relative to Aberdeen Asian Smaller Companies, Scottish Oriental has outperformed in NAV terms over one, three and five years and we think the group’s explicit focus on capital preservation, broader diversification, superior dividend cover and cau-tious use of gearing appeals in the context of a mixed short-term outlook for Asia.

Finally, we think the collegiate approach that First State has always taken must be given some credit with regard to recent movements at the top. Whilst on paper the leadership of this trust appears to have been trapped in a revolving door, in practi-cal terms there has only been one lead manager on the fund since the departure of Susie Rippinghall – Wee Hi Lee. She is sup-ported by two of the new management company’s most senior figures. With its outstanding track record, it is a flagship for the new semi-independent venture. With this in mind, they have everything to play for.

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Ticker SST

Management Company

First State Investment Management (UK) Sector

AIC Asia Pacific ex Japan Benchmark

MSCI AC ASIA PACIFIC ex JAPAN

Z-Score (1 yr, cum inc) -1.58 Dividend yield (%) 1.42 Dividend Frequency Annual Market Cap (£m) 255.5

Net Assets (Ex £m) 284.9

Net Gearing Cum 95

OC (excl perf fee) 1.022

LSE turnover (1 yr daily £m value) 0.22

Key information Objective: To achieve long-term capital growth by investing mainly in smaller Asian quoted companies with market capitalisa-tions under US$1,000m at the time of investment, or the equivalent. Asia is deemed to include the Indian subcontinent but ex-cludes Japan and Australasia.