SWZ - Swiss Helvetia Fund: Fade The Wider-Than-Usual NAV Discount

2023-05-03 21:42:18 ET

Summary

• The Swiss Helvetia Fund is up YTD but continues to lag its benchmark.
• Distribution has been strong, but the % yield contribution from recurring income is down.
• With an external slowdown and more monetary tightening set to weigh on Swiss equities as well, the near-term setup isn't compelling.

Following my prior coverage of the actively managed Swiss Helvetia Fund ( SWZ ), the fund has undergone some uncharacteristic volatility – a shift from the general investor perception of Swiss large-caps as defensive 'safe havens.' Yet, the turbulence following Credit Suisse's ( CS ) failure in March and the subsequent takeover by UBS Group ( UBS ) has come and gone with little fuss. Despite the outsized contribution of the banking sector to the Swiss economy, swift regulatory intervention by the government and the SNB (the Swiss central bank) has allowed for limited financial contagion. That said, equity valuations could still come under pressure from tighter liquidity conditions as the SNB catches up with the ECB's extended tightening cycle. And even though SWZ's holdings shouldn't be too badly hurt in a domestic recession, earnings could suffer downward revisions amid external weakness in their key markets (China notwithstanding). In the meantime, paying a ~1.7% expense ratio (per the latest annual report ) for a fund manager boasting a below-par stock picking track record doesn't seem particularly appealing here – even at a mid to high-teens % NAV discount.

Fund Overview – Steep Expense Ratio for an Easily Replicable Large-Cap Swiss Portfolio

The NYSE-listed Swiss Helvetia Fund, a closed-end investment fund managed by Schroders ( OTCPK:SHNWF ), aims to achieve long-term capital appreciation through investments in listed Swiss equities. The closed-end fund held ~$131m of net assets at the time of writing, above the ~$116m in reported net assets in FY22. Of note, the fund's expense ratio has drifted higher to 1.7% as a % of average assets (vs. 1.4% prior), with ~70bps earmarked for management fees to Schroders. The remaining >90bps of expenses (director fees, admin, legal, etc.) seems excessive, given the many investment options available to investors looking to access Swiss equities.

The fund's sector allocation has generally remained consistent with prior years. Defensive names dominate the portfolio, with healthcare (30.5%), consumer staples (21.6%), and financial services (17.9%) accounting for the lion's share of the fund's holdings per the latest annual report. Given the sector composition is largely in line with the benchmark Swiss Performance Index, there isn't a lot of input by the manager on the sector selection front.

The single-stock portfolio has also seen limited changes, with SWZ's Q1 reporting showing that the largest holding remains food and beverage conglomerate Nestle SA ( OTCPK:NSRGY ), at 19.2% (slightly down from 19.5% prior). While pharmaceutical corporation Novartis AG ( NVS ) has been bumped up to the second spot (from third previously) at 10.5%, its portfolio contribution is slightly below the 11.1% prior. Biotech leader Roche Holding AG ( OTCQX:RHHBY ) is the third largest allocation at 10.4% (down from 12.2% prior), with luxury goods brand Compagnie Financiere Richemont ( OTCPK:CFRHF ) still the last holding over the 5% threshold. Expect a similar composition for the foreseeable future as well, given the manager's low portfolio turnover.

Fund Performance – Underperformance Continues; Distribution Yield is Consolation

On a relative basis, SWZ's track record has been underwhelming, to say the least. On a YTD basis, the fund has returned a solid 9.4% vs. 7.8% for the benchmark Swiss Performance Index but on a one-year timeline and beyond, the fund has consistently underperformed by ~1%pt annualized (post-distributions) despite the high expense ratio. The quarterly distribution has been steady through the cycles, however, which will appeal to income investors. Yet, early indications point to a weaker run rate this year - Q1 saw $0.12/share of distributions , down from $0.17/share in the prior year ($0.62/share total). While the implied ~6% yield seems attractive on paper, most of the Q1 payout (~77%) has come from the fund returning capital rather than investment income, so the run rate could still normalize lower in the coming quarters.

Valuation Pressure Ahead as the SNB Rate Hike Cycle Continues

Following two stronger-than-expected inflation prints, the prospect of higher and stickier Swiss inflationary pressures has become top of mind for the SNB. With the ECB also outpacing the SNB with its tightening cycle, it was no surprise that the SNB raised its policy rate by 50bps to 1.5% at its latest monetary policy meeting.

While the fragility of the banking system following Credit Suisse's failure remains a factor, the prompt response from Swiss authorities to limit the fallout seems to have allayed the SNB's concerns for now. In turn, price stability looks set to take precedence over financial stability, paving the way for more hawkish policy updates in the coming months. The SNB's post-meeting statement supports this view, citing "additional rises in the SNB policy rate will be necessary to ensure price stability over the medium term." So even though the defensiveness of the Swiss equity market could attract 'safe haven' flows in the near term, more tightening (via rates and slower lending post-CS) presents downside on the valuation front.

External Weakness Could Weigh on Earnings

A result of the tightening headwind globally is a less supportive external outlook, with weakness in key Swiss export markets likely to drive another year of slower growth (a far cry from the extremely strong 2021). A key driver is Switzerland's linkage to global trade as a small, open economy; in particular, Western economies such as Europe and the US, where downside risks to growth are growing, tend to have an outsized impact.

The domestic economic backdrop isn't helping either – momentum has slowed across the board in the last six months, and even manufacturing PMI numbers, previously a bright spot, have moved lower. Expect another quarter of stagnating GDP ahead as declines in exports and manufacturing output continue. Also worth watching will be the pace of inflation as electricity prices normalize higher and services inflation accelerates toward the +2% YoY mark. Unless the China reopening accelerates meaningfully from here (GDP growth currently targeted at ~5%), even through-cycle cash generators like Nestle and Richemont could suffer some earnings downside in the coming months.

Fade the Wider-than-Usual NAV Discount

The Swiss Helvetia Fund may have recovered from the financial turbulence triggered by CS' failure in mid-March, but the near-term outlook remains cloudy. While the defensive characteristics of Swiss large caps look appealing, the backdrop of slowing external growth and monetary tightening globally could weigh on earnings in the coming months. And while the fallout from the Swiss banking crisis hasn't yet filtered through to the economy, its outsized contribution to GDP is a concern; the prospect of slower credit growth and lower investments means a Swiss recession may now be firmly back on the table. And with the SNB also forced into an extended tightening cycle to catch up with the ECB, valuations could come under further pressure. With SWZ's elevated expense ratio offering investors little bang for their buck (case in point – the poor stock selection track record), investors would be better off with a low-cost passive alternative.

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