BlackRock Commodities Income

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1 Material produced by Kepler Trust Intelligence is a marketing communication, and is not independent research. BlackRock Commodities Income Update 15 August 218 Summary (BRCI) has a conviction-led approach to delivering a high income (currently yielding 4.8) from the global mining and energy sectors. The managers have flexibility to use fixed income and option writing to boost income when the opportunity arises. Managed by Olivia Markham and Tom Holl, BRCI typically has an even split between mining and energy stocks. A large chunk of the trust is invested in larger, dividendpaying companies and with the top ten holdings currently accounting for 55 of total assets, relative to most equity funds it can be considered highly concentrated. The team s focus on income and higher quality has meant BlackRock Commodities Income has tended to generate its relative outperformance in flat or falling markets. The experience year-to-date diverges from this pattern, with the trust outperforming handsomely, generating NAV total returns of 8.9 against 5.6 from a 5/5 combination of the EMIX World Mining index and the MSCI World Energy Index. Much of this outperformance has been driven by stock selection, especially from smaller E&P names, where stock prices have finally started to reflect the solid results that these companies are delivering. Income has been (and continues to be) a major focus for the managers and board. However, the trust was not insulated from the dividend cuts experienced by the sector, and the board reduced the dividend from 6p paid in 215 to the current level of 4p (paid in 217, and the target for 218). Whilst frustrating for shareholders, there are signs that the reduction in the dividend may have reached its furthest extent. The 217 finals and 218 interims both showed an improvement to overall income earned and a covered dividend once again. Given current commodity and oil prices, not to mention the effect of sterling s depreciation against the dollar so far this year, the managers appear to be cautiously optimistic on revenues. Portfolio has a relatively concentrated portfolio of between 4-5 holdings, focussed on the team s best ideas in the energy and mining sectors. The trust has an overwhelming income mandate and invests in equities and fixed income, as well as using an options strategy to provide as high an income as possible for shareholders. The portfolio is constructed using top-down and bottom-up research, but the team set great store by meeting companies. The top-down analysis is formed by views on the medium-term outlook for commodity and oil prices. Much of this macro view is based on views influenced by company meetings. For example within the energy sector, the portfolio currently has an overweight position in what the team views as solid E&P companies with relatively low gearing, which should deliver healthy free cashflows 1

2 assuming an oil environment of $5-6 per barrel. This reflects the team s view that they want to own stocks that can grow profits in a flat market for commodities, but also benefit from upside to commodity prices. This higher quality preference is a reflection of the trust s income mandate, with the managers focusing on solid companies that are good allocators of capital and tend to have an attractive dividend policy. The managers argue that taking an income approach to such a cyclical area of the market makes sense, especially as dividends have been a major driver of total returns for the sector over the longer term. The managers typically split the portfolio relatively evenly between the energy and mining sectors. As at 3thJune, 45 of the portfolio is exposed to energy, while 56 is in mining. However, within the mining exposure around 1 is represented by fixed income, which means that the true exposure to equities is more finely balanced. The team is allowed to hold up to 1 of NAV in stocks in the agriculture sector, though historically this has represented a small part of the portfolio. Fig.1: Asset Allocation A large chunk of the trust is invested in larger, higherquality companies, as shown in the table below. The top ten holdings currently account for 55 of total assets, which relative to most equity funds might be considered highly concentrated. Top Ten Holdings as at 3th June 18 Diamonds Industrial minerals Copper Distribution Steel Silver Allocation as at 3th June 218 Oil Services Integrated Oil NAME OF TOTAL ASSETS Rio Tinto 8.7 Gold BHP 8.3 Royal Dutch Shell 6.8 First Quantum 6.2 Source: BlackRock Exploration & Production Glencore 5.7 Chevron 5 BP 4.4 Exxon Mobil 3.7 Marathon Oil 3.2 ConocoPhilips 3.1 Total 55.1 Source: BlackRock As we discuss in the dividend section, option writing has been a profitable strategy given the highly volatile nature of the sector, and in 215 and 216, premium income has formed more than 5 of the trust s underlying income generation. The contribution from option writing has come down of late, reflecting the calmer state of equity markets and lower implied volatilities. At any one point, around 7-1 of the portfolio will have options over it. The managers participate in option writing (covered calls, and writing puts) tactically and on individual stocks, but not as a blanket programme. Option writing in this manner can have the effect of diluting capital returns, but employed successfully, can add a useful extra layer of returns which (given all of the options are originally written out of the money) constitute as income. The team continues to be positive on both energy and mining. Within the energy sector, the team has had a longheld view (which the market is increasingly coming around to) that increasing management focus on shareholder returns, and the corresponding lack of investment in supply will start to have an impact on the oil price, as well as the free-cash flows that these companies exhibit. When we spoke to Olivia Markham recently, she commented that in her view the big oil companies are where the diversified miners were two years ago. In the trust managers minds, the market still isn t giving the oil company managers the benefit of the doubt that they will continue to prioritise shareholder returns over volume growth, and that earnings and free cash flow will exceed expectations. In order to profit from the team s bullish view on the oil price, the team has held various exploration and production (E&P) names with a historically high beta to the oil price currently c 16 of NAV. When we last wrote about BRCI, this element of the portfolio was lagging, reflecting general nervousness about the sustainability of oil prices. Since then, the E&P stocks have been some of the strongest contributors to the excellent performance delivered by the trust YTD. The managers bullishness on mining stems from a continuation of what they view as strong underlying demand for commodities. Prices of shares and commodities 2

3 have been blown off course by trade war headlines, but the managers believe the fundamentals remain strong. The team continues to believe 218 will see high levels of free cash flow in the mining industry translate into returns to shareholders, rather than into increased capacity. The trust is global in nature, with the large majority of holdings generating earnings from all around the world. The very large majority of portfolio companies report earnings in US dollars, which means that the shareholders have an element of currency exposure particularly with regard to dividends. The team s focus on income and higher quality stocks has meant has tended to generate its relative outperformance in flat or falling markets. The experience year to date (YTD) diverges from this pattern as the graph below shows. So far the trust has outperformed, generating NAV total returns of 8.9. This compares to 5.6 from a 5/5 combination of the EMIX World Mining index and the MSCI World Energy Index. We understand that much of this outperformance has been driven by stock selection, especially from the team s copper exposures (particularly Avanco and First Quantum), as well as their smaller E&P names. Peer group The commodities and natural resources sector is widely populated for such a specialist sector. With a yield of 4.8, BRCI has the highest yield by quite some way. The defensive stance of the trust has put it in good stead over the past few years, and it has been one of the top two performing trusts over six months, one, three and five years. It is worth noting that the BlackRock natural resources team is one of the largest and best resourced specialist teams around the world. Gearing The trust operates a flexible gearing policy, which depends on prevailing market conditions. The team does use this flexibility, with the level of gearing increasing at one point earlier this year to c.11 - reflecting the greater level of fixed income exposure within the trust, as well as the managers more positive outlook for both the mining and energy sectors. The gearing includes the trust s derivativesbased fixed income exposure, as well as a traditional overdraft facility. It has subsequently reduced to the current level of c 5. Fig.2: Gearing Fig.3: Performance /FE Analytics NAV returns vs peers and benchmark Oct '17 Jan '18 Apr '18 Jul '18 5 EMIX Global Mining / 5 MSCI World Energy Morningstar IT SS: Commod ities MSCI World Over the longer term, during what has been a severely volatile time for mining and energy companies, the trust has struggled against the composite benchmark. Nevertheless, the trust s more conservative approach is evidenced by the fact that it has beaten its peers in five of the past eight calendar years. Fig.4: Discrete Annual Returns Vs Peers and Indices 115 Gearing 1 Annual returns 75 (1 = ungeared) NAV 5 EMIX Global Mining / 5 MSCI World Energy Morningstar IT SS: Commodities NAV MSCI World 3

4 In the graph below we illustrate the trust s NAV total return performance relative to comparators over five years. The trust s more defensive positioning has meant that the trust has outperformed many of its peers over the medium term, as it protected capital far more effectively during the severe down cycle for natural resources between 211 and 215. Latterly, this defensive positioning meant that BRCI struggled over the course of 216 and 217 in what were more positive market environments. Fig.5: Performance pence per share Dividend NAV returns vs peers and benchmark EMIX Global Mining / 5 MSCI World Energy Morningstar IT SS: Commod ities MSCI World Generating an income is a key part of the strategy. The trust, up until 216, had a good track record of dividend growth, but given the widespread dividend cuts that affected the mining (and to a lesser extent) energy sectors, the board reduced its dividend target to 5p in 216 (down from 6p the year before) and to 4p for 217, with 1p per share paid quarterly. In the recently published interims, the board reaffirmed its commitment to a 4p dividend, which puts the trust on a yield of 4.8 at the current share price. Fig.6: Dividend Dividend and revenue per share Whilst frustrating for shareholders, there are signs that the reduction in the dividend may have reached its furthest extent. In the 217 full year results, the trust showed an improvement to overall income earned, with the revenue return increasing to 4.84p from 4.43p meaning the trust once again paid a fully covered dividend. In the interims, the dividends for the first six months were also covered by earnings. Going forward, the key drivers to the dividend are the larger global companies, which have largely moved to payout ratios based on profitability. This means that dividends will be largely derived from changes in commodity prices, and as such the managers are expecting modest increases, assuming the macro picture doesn t change too much. The fact that almost all of the portfolio companies pay dividends in dollars means that the company will also likely benefit from the weakening of sterling against the dollar year to date with sterling moving from c in April 18 to the current level of The managers have previously stated that they expect a lower contribution from option writing going forward (which during 215 and 216 accounted for more than 5 of the trust s income). At the time of the interims, over the sixmonth period to 31st May 218, option writing contributed c. 33 of portfolio income. Option writing is expected to contribute a varying proportion of income, although by the manager s admission, 5 was unsustainable over the long term. That the contribution from option writing has come down, yet the board is still committing to the dividend level of last year, is encouraging, and gives the managers more room for manoeuvre should income conditions become tighter again. The team retains the flexibility to step option writing activity up should dividend income disappoint or the environment for options become materially better again. At the time of the final results (end November 217), the revenue reserve, stood at 2.96p, which translates into.74x the current 4p level of dividends. The board stated at the time that it will look to protect any future shortfall in earnings with reserves. At this level, the trust yields considerably more than most other areas of the market (Global Equity Income investment trusts yield 3.9). The managers believing that many companies in both energy and mining are committed to returning cash to shareholders and more disciplined capital spending decisions Source: BlackRock Dividend per share Revenue return per share 4

5 Management Olivia Markham and Tom Holl have managed the trust since January 214 and both are members of the Natural Resources team within the Fundamental Equity division of BlackRock's Alpha Strategies Group. The duo manage a variety of natural resources strategies for the group, with Oliva co-managing BlackRock World Mining and Tom running various open-ended funds such as BlackRock Gold & General and BlackRock Natural Resources Growth & Income. Given the size of BlackRock as a group, Olivia and Tom have a huge amount of support and access to a wide range of resources. Not only do they work closely with the rest of the natural resources team and are supported by BlackRock s sizeable risk management team, the managers note that one of the major benefits has been working alongside the variety of other equity and credit teams with Tom and Olivia regularly attending company meetings with members of different desks from around the firm. It is worth noting that the board has the discretion to make semi-annual tender offers at the prevailing NAV, less 2, for up to 2 of the issued share capital in August and February of each year. However, the board decided not to proceed with a tender offer at the last few opportunities, thanks to the relatively narrow discount against the tender level of NAV less 2. Charges The trust s management fee is equal to.95 of gross assets p.a. and will reduce to.9 p.a. for gross assets in excess of 25m. The trust s net assets are currently c 12m. The fee is levied quarterly, based on the gross assets on the last day of each quarter, and is charged 25 to the revenue account and 75 to the capital account. Overall, has an ongoing charge of There is no performance fee. Discount Despite commodity-related stocks being hugely out of favour for many of the past few years, BlackRock Commodities Income had traded on a premium over much of that period thanks to its dividend profile and the manager s more conservative approach to the market. The plan is to grow the trust, with the board having issued shares consistently in 215 and 216, but the lowered dividend target for 217 weighed on sentiment, with discount widening out. 218 saw a spike in strong enthusiasm, and the board issued a small number of shares again in March. This proved short lived, and the board has bought shares back at a discount of 6 in the early summer. The shares now trade at a discount of 3.7. Fig.7: Discount 2 Discount to NAV Morningstar IT SS: Commodities 5

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