BlackRock Commodities Income

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1 is a client of Kepler Trust Intelligence. Material produced by Kepler Trust Intelligence should be considered as factual information only and not an indication as to the desirability or appropriateness of investing in the BlackRock Commodities Income Summary (BRCI) has a conviction-led approach to delivering a high income from the global mining and energy sectors. The shares currently yield 5.7, considerably more than funds exposed to many other areas of the market. The managers have flexibility to invest in equities and fixed income to generate this income. With the top ten holdings currently accounting for 51 of total assets, relative to most equity funds it can be considered highly concentrated. Managed by Olivia Markham and Tom Holl, BRCI typically has a roughly even split between mining and energy stocks. Reflecting the income mandate as well as the current outlook of the managers, a significant proportion of the trust is invested in the larger, diversified companies within each sector. The managers believe that within both of these sectors, diversified mega-caps are hugely cash-generative at current commodity price levels. With solid balance sheets and management focused on shareholders, they seem set fair for dividend hungry investors. BRCI s objectives are to achieve both an annual dividend target and, over the long term, capital growth. The board considers a reference index, of 5 EMIX Global Mining and 5 MSCI World Energy Index to compare performance, but does not see it as a benchmark, given the high-income mandate of the trust. Over the longer term, during what has been a severely volatile time for mining and energy companies, the trust has not kept pace with the reference index. 218 started very positively, with the managers generating significant outperformance of the reference index, only to see worries of a China slow down and trade wars, erode it. BRCI has started 219 in a positive manner, with the NAV at the time of writing, outperforming the AIC peer group which is -.6 in NAV terms. 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. In the recently published annual results, the board has renewed its commitment to targeting 4p for the financial year ending 3th November 219. Portfolio Update 1 February 219 Analysts: William Heathcoat Amory +44 () Pascal Dowling +44 () Thomas McMahon, CFA +44 () William Sobczak +44 () Kepler Partners is not authorised to make recommendations to Retail Clients. This report is based on factual information only. The material contained on this site is factual and provided for general informational purposes only. It is not an invitation or inducement to buy, sell or subscribe to any product described, nor is it a statement as to the suitability or otherwise of any investments for any person. The material on this site does not constitute a financial promotion within the meaning of the FCA rules or the financial promotions order. Persons wishing to invest in any of the securities discussed in the website should take their own independent advice with regard to the suitability of such investments and the tax consequences of such investment. s objective is to achieve both an annual dividend target and, over the long term, capital growth. It typically has a concentrated portfolio, with the top ten holdings currently representing In total, the managers expect to have a total of between 4-5 holdings, focussed on their best ideas in the energy and mining sectors in roughly equal proportions. The trust has an overwhelming income mandate and invests in equities and fixed income to provide as high an income as possible for shareholders. The current split between energy and mining can be seen in the graph below. Within the mining exposure, around 11.4 of the trust s portfolio is represented by fixed income, which means that the true equity exposure to each sector is more finely balanced. 1

2 Top Ten Holdings As At 31St December 18 Fig.1: Portfolio Sector Split Oil & energy Allocation as at 31st December 218 OF TOTAL ASSETS BHP 9.5 Royal Dutch Shell 6.8 Rio Tinto 6. Chevron 4.7 Teck Resources 4.6 Exxon Mobil 4.6 BP 4.3 First Quantum Minerals Vale - ADS 3.6 Glencore 3.6 Total 51.4 Metals & mining The portfolio is constructed using top-down and bottomup 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. The trust s current positioning is a case in point, with BRCI most exposed to the very large diversified miners who are the lowest cost producers of metals globally. According to Olivia, they are likely to be cash machines for the forseeable future, with low capex requirements and an ability to extract and sell their products for a high cash margin. As we discuss in the performance section, this approach has done the trust well over the past year or so and was a decent contributor to outperformance of the benchmark in the first half of the year. Worries over the impact of trade wars have dulled performance from the mining sector somewhat. and renewables sectors, preparing for what they describe as the inevitable upcoming energy transition. This is both in equities, but also in fixed income. For example, the team report that they are able to invest at attractively high yields in bonds issued by lithium miners, who cannot access bank finance in the traditional way because of the lack of an effective hedge (for the banks) for the lithium exposure. The managers are positive on the prospects for the lithium companies they hold, given their role in the energy transition to electricity and electricity storage, and are so very happy to earn such high returns. Overall, around 3.1 of the portfolio is directly invested in electricity producers (ENI) and distribution. On the energy side of the portfolio, the team s earlier decision to ramp up their investment in exploration and production (E&P) companies looked like a good move when the oil price continued its rise from 217 into 218. The team had started to take profits when oil hit $85 in September 218, but admit they could have been more aggressive after the oil price fell precipitously in Q4. Having been at c 16 when we last wrote on BRCI in August 218, the team still have 8.4 exposure to E&P companies, which they characterise as solid, with relatively low gearing, and which should deliver healthy free cashflows assuming an oil environment of $5-6 per barrel. Given the lack of clarity on global GDP, the team are retaining their exposures to the big integrated oil producers. They reason that cap-ex in the sector still hasn t recovered, and whilst there is excess supply globally, there are signs that the lower oil price is choking some of it off. With balance sheets very healthy, and a focus from the larger companies on shareholder returns, they are being paid to wait (through high dividends) for the recovery. 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 Fig.2: Asset Allocation Integrated oil Electricity Exploration & Prodn Allocation as at 31st December 218 Distribution Diversified miners Within the mining sector, but married to what they are hearing in the energy sector, the team have been increasingly putting money to work in the battery materials Diamonds Silver Industrial minerals Gold Copper 2

3 that are good allocators of capital which 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 team continue to be positive on both energy and mining. Withinboth sectors, the team continue to hold the view that increasing management focus on shareholder returns, and the corresponding lack of investment in supply will mean attractive free-cash flows and dividends for investors. Both sectors are under-owned by institutional investors, and in Olivia s view remain highly attractive from an income perspective. Prices of shares and commodities have been blown off course by trade war headlines, but the managers believe the fundamentals remain strong. Olivia observes that the greatest risk is a global recession, in which the trust will struggle to perform. Dollar weakness would also hurt, particularly with regard to dividends given most companies report earnings in dollars. However, Olivia points out that dollar weakness also has the effect of boosting demand for commodities and energy from emerging markets, so the negative effect from dollar weakness is perhaps more nuanced. Gearing The trust operates a flexible gearing policy, which depends on prevailing market conditions and over the past year has fluctuated between around 11 and 5. The graph below shows the past five years history. It is worth noting that this includes the trust s derivatives-based fixed income exposure, as well as a traditional overdraft facility. Overall, the team tend to balance gearing with fixed interest holdings, which means that shareholders do not tend to have a significantly geared equity exposure. find it difficult to borrow from banks, given the banks can t hedge the lithium exposure. As such, the team report achieving coupons as high as 11 by having exposure to companies such as Nemaska and Pilbara. These bonds enable a significant pick-up over the trust s cost of borrowing. Returns BRCI s objectives are to achieve both an annual dividend target and, over the long term, capital growth. The board considers a reference index, of 5 EMIX Global Mining and 5 MSCI World Energy Index to compare performance, but does not see it as a benchmark, given the high-income mandate of the trust. As we discuss in the dividend section, the trust has come through a difficult period for dividends generally, and all the signs are that this is now very much behind it. In a total return sense, the team s focus on income and higher quality stocks means that BRCI should generate its relative outperformance of the reference index in flat or falling markets. However, during what has been a severely volatile time for mining and energy companies, the trust has struggled against it. 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. BRCI has started 219 in a positive manner, with the NAV at the time of writing (to 29th Jan 219), outperforming the AIC peer group which is -.6 in NAV terms. Fig.4: Discrete Annual Returns Vs Peers And Indices 1 Annual NAV returns (in GBP, YTD to 29th Jan 19) As we refer to in the portfolio section, the managers are finding interesting opportunities in the fixed income markets, particularly with various lithium companies that 5 Fig.3: Net Gearing (1 = ungeared) Source: Morningstar Gearing Jul Sep-18 5-Dec-18-5 Source: Morningstar/Kepler Partners Ord (Cumulative Fair NAV) 5 EMIX Global Mining / 5 MSCI World Energy MSCI World NR USD Morningstar IT: Commods & Nat Resources In the graph below we illustrate the trust s NAV total return performance relative to the reference index and global equities over five years. Prior to this period, it is worth noting that the trust protected capital far more effectively than peers during the severe down cycle for natural resources. Latterly, this more defensive and conservative positioning has meant that BRCI struggled to keep up with the benchmark over the course of 216 and 217 in what were more positive market environments. 3

4 Fig.5: Performance NAV total returns vs benchmark Source: Morningstar/Kepler Partners 5 EMIX Global Mining / 5 MSCI World Energy MSCI World BRCI has had a very strong start to the new year, having kept pace with the reference index in the rebound, and outperformed global equities. As the graph below illustrates, the managers outperformed handsomely last year up until September 218 through their exposure to E&P oil stocks and having exposure to the larger, diversified miners. However, fears of a slow-down in China and a trade war meant that the relative gains were given up in the last quarter of last year. Fig.6: Performance 2 1 NAV total returns vs reference index & peers or capital reserves, which in our mind indicates that the dividend yield of 5.7 looks relatively secure. This commitment is important, within the context that the board had to reduce the dividend to the current level (from 6p paid in 215). Up until 216, BRCI 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 and to 4p for 217, with 1p per share paid quarterly. The board s reaffirmation that 4p remains the target gives confidence that this will be the nadir for the dividend level. During the 218 financial year, the revenue return per share declined 9.7, which resulted in earnings of 4.37p with the dividend covered. We calculate that revenue reserves stand at.6x the current 4p annual dividends. Historically, when market conditions allowed, the managers have opportunistically used option writing to boost income. We note that during 215 and 216, option writing accounted for more than 5 of the trust s income, but this has come back as a proportion as market volatility has retreated. In the recently published annual report, the board has stated that it would be happy to see the managers employ less option writing going forward, and that it will cover any earnings shortfall with revenue or capital reserves. The team retain the potential to employ the strategy again. Fig.7: Historic Dividend Dividend and revenue per share Source: Morningstar/Kepler Partners Dividend Apr '18 Jul '18 Oct '18 Jan '19 5 EMIX Global Mining / 5 MSCI World Energy Morningstar IT SS: Commod & NR One of the key attractions for BRCI is its high dividend yield, which suits the underlying mining and energy sector exposure because of their ability to generate very significant amounts of cash. The current dividend of 4p per year (paid quarterly) is equivalent to a yield on the share price at the time of writing of 5.6, which is very much higher than most other generalist equity income funds. In the most recent annual report, the board has reaffirmed its commitment to a 4p dividend for the financial year ending 3th November 219. The board also stated that it will look to protect any future shortfall in earnings with revenue pence per share Dividend per share Revenue return per share As we discuss in the portfolio section, the trust remains exposed to some of the largest and arguably more defensive global companies in the mining and energy sectors, which are all generating enormous amounts of cash thanks to lower cap-ex and their very low production costs. Given that they have largely moved to payout ratios based on profitability, over the long run dividends should be more sustainable. Almost all of the portfolio companies pay dividends in dollars, meaning that even with the recent 4

5 strength in sterling, it remains weaker than when we last wrote on BRCI in August when we noted that cable was 1.32 (1.3 at the time of writing). At this level the trust yields considerably more than most other areas of the market (Global Equity Income investment trusts yield 4.1 (source: JPM Cazenove)). 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. Discount As the graph below shows, BRCI has consistently traded at a significant premium to its peers in the Commodities and Natural Resources investment trust sector. The main reason for this is clearly the focus on yield, but also the board s activities which have kept a fairly tight control of the discount. The board has historically been fairly active, both on the issuance and buyback front. Latterly, it has been buying back shares the most recent of which Fig.8: Discount Discount to NAV was on 22nd October 218, when (by our calculations) it purchased shares on an 8.2 discount. Over the last financial year, the average buyback level was a discount of 6.6. Historically has traded on a premium to NAV. However, the lowered dividend target for 217 (announced in mid-216, and clearly observable in the chart below) hit sentiment, which has weighed for much of the time since with the discount widening out. It hasn t all been one-way traffic however, and 218 saw a spike in enthusiasm, with the board issuing a small number of shares again in March on a premium of 2.2. The shares trade at a discount of 5.3 at the time of writing. Last month (December 218), we reviewed the investment trust universe and used a proprietary technique to identify trusts which have rarely looked cheaper (to their own history) in discount terms. BRCI was one of them, and as the graph below shows, on a discount basis the trust has rarely looked cheaper being well into the bottom decile of cheapness. Fig.9: Brci Distribution Of Discount Over Ten Years discount to NAV Source: Morningstar, Kepler Partners BlackRock Commodities & Income 1 years of average monthly discounts BRCI Decile Average We continue to observe that there are relatively few trusts which offer an above average yield but that trade on a discount especially one that is well covered by revenue reserves and has the potential to grow over the coming years. Historically, the board has had 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. In the recently published annual results, the board has stated that it sees buybacks as more appropriate and so will not be seeking authority to make semi-annual tenders henceforth Source: Morningstar Morningstar IT SS: Commod & Nat Resources 5

6 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 gross assets are currently c 92m. 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 1.39 (financial year ending Nov 18). There is no performance fee. 6

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