Dunedin Income Growth Investment Trust manager update: Ben Ritchie and Rebecca Maclean

In this latest episode of the abrdn Investment Trusts podcast, we are joined by Ben Ritchie and Rebecca Maclean, managers of Dunedin Income Growth Investment Trust. They provide a macro update, discussing interest rates, inflation, recession and the impact on the Trust's positioning. 

For more information: dunedinincomegrowth.co.uk 

Transcript

Cherry Reynard: Hello, welcome to today's podcast on the Dunedin Income Growth Investment Trust. I'm Cherry Reynard, and with me today are the Trust managers, Ben Ritchie, and Rebecca McLean. We're here to discuss all things interest rates, the economy and how that's influencing positioning on the Trust. So welcome, Ben, welcome, Rebecca.

Now, Rebecca, you've joined the Trust quite recently. So I wonder if you could sort of introduce yourself and talk a bit about your background.

Rebecca: Yes, thank you, Cherry. So good to speak today. As you say, I joined the Trust earlier on this year, having been in responsible investment for 12 years, I have seen it move from niche to the mainstream. And I started my career as a Responsible Investment Analyst at abrdn, where I was doing thematic research into environmental and social issues and corporate engagement on ESG topics. So that's, that's where I've come from. But I moved to the UK equity team about six years ago as an investment director, and have been managing mostly sustainable funds. So the UK sustainable Fund and the UK ethical fund are the sort of two funds I've been working on, in addition to some others. So, I think this provides a useful background and experience for this investment trust, given its UK exposure, but also the relatively recent sustainable approach, which has been included in the fund approach. And I think places the Trust in quite a unique position within the UK equity income sector is differentiated and the sustainable investment criteria really stands it out within the broader sector. So I'm delighted to be on the Trust and working alongside Ben. 

Cherry: Great. Okay, thank you, Rebecca. I'll, I'll direct the first question to you if I if I may. So, this week saw a big interest rate hike from the Bank of England. But on the other hand, there were some sort of relatively warm words about interest rates not having to rise much more at the same time. What have you seen in terms of the impact on investment markets?

Rebecca: Yes, indeed, the Bank of England raised rates this week by 75 basis points, taking the bank rate to 3%. And this is in the context of high inflation that we have in the UK, reaching over 10% in September. But meanwhile, as you, as you say, the bank did strike a dovish tone, pointing to market expectations for peak rates, and suggesting there were too high. And I think the reason for this and speaking to our economists at abrdn, this is because looking into next year, there is some concern around the health of the UK economy. Indeed, our economists are expecting the UK economy to contract next year and for there to be a recession, which could last longer than some expect. 

So, on the back of this, we've seen, you know, some quite dramatic shifts in the market. And we've spoken about these on the podcast already this year. But there's been a strong rotation in the market into value sectors and away from some quality and growth sectors. And whilst the UK index did recover, and rose in October, some of those trends continued. So, energy did particularly well.

But there is some level of optimism in the market around the pace of central bank rate increases and looking to the potential for those to start to slow. But high interest rates and inflation do create headwinds for corporate earnings, particularly companies that have got a lot of leverage are going to face higher refinancing costs. And companies are having to deal with commodity price inflation. So, as I say these, this does benefit certain sectors like energy, but it has, you know, it’s a difficult situation for many companies to manage when they look out to next year. 

So, what are we doing? Well, we continue our approach to focusing on bottom up stock selection. And we think that going forward, the environment should be more balanced for stock picking. Valuations are depressed in anticipation of a slowdown. And we think that this is creating some mispricing opportunities, which we're looking to take advantage of. So, the threat of inflation, a potential global downturn will put pressure on earnings. But we think that the companies that are held in the Investment Trust should be relatively well placed to manage these challenges. The Trust is looking to invest in quality companies with strong pricing power and healthy balance sheets. And indeed, companies which are managing their environmental, social and governance risks. And these companies should emerge from a recession in a stronger position and do relatively well. So we're mindful of that the uncertainty in the outlook, but we're, we're focused on our approach, this isn't changing. And indeed, we're looking to take advantage of some of the share price weakness to add selectively to companies that we think are mispriced on a medium term view.

Cherry: Great, okay, thank you. Ben, if I bring you in here, Sterling has continued to be pretty weak in spite of some stability returning to UK politics. I know you've got a fair bit of international exposure in the Trust. Have you seen companies benefiting from that either on the sort of capital growth or earnings or dividend side?

Ben: Well, I think overall weaker sterling is good news for UK equities. Seventy percent or so of revenues in the market come from overseas and broadly speaking, weaker Sterling drives, you know, higher translation of revenues, probably drives enhanced profit margins and, and drives better cash and ultimately, better dividend distributions for investors. So weaker Sterling isn't all bad for UK equities. 

I think overall, in terms of our positioning, you know, we're a little bit overweight in the mid cap part of the market, we've got about 25% of the portfolio, maybe 30, if you add in some of the small caps into that area, that probably puts us 10 percentage points overweight, the mid cap space, and that typically tends to be a little bit more domestic in terms of its exposure. And that's probably been the area that's been, they've been the weakest part of the portfolio this year, as the economy has proven challenging, where companies have had input costs in dollars to deal with and revenues, perhaps more in sterling. 

But I think overall, for the portfolio, we're probably fairly neutral in terms of our exposures. And it's really, I think, you know, a sort of fairly sort of mixed picture really, so Sterling is good overall, for the market, terms of our relative positioning, it's fairly neutral.

Cherry: Okay, great. And sticking with you. I mean, what are the prospects for dividend growth over the next kind of six months or so? I mean, can companies still deliver as the economy weakens? Or do investors need to be prepared for some stagnation in their in their income?

Ben: Yeah, I think 2022 has been a year where dividend distributions have surprised on the upside. So that's been one of the really positive dynamics for us this year has been a much better out turn for income than we'd expected at the start of the year. But I think you can start to see some of those headwinds starting to kick in. And I would say, dividend distribution tends to be quite backend loaded, it's quite late cycle. So, you know, companies need to start to find initially, they'll sort of hold their dividends or grow them a little bit, it takes a while before the rate of growth, and perhaps dividend cuts start to start to come through. So I think it you know, does always tend to be a bit late cycle – ’22 has looked pretty good, but I suspect it will get a bit more cautious messaging at the start of 23. And if we are going to see dividend cuts, I suspect they would probably start to come in as we move through interim reporting in ‘23, and four-year reporting ‘24. So, it's some way away. 

I mean, this year has been, you know, been very good. But I think we still feel that underlying, you know, the portfolio can generate a healthy, mid-single digit type revenue growth from the companies in the portfolio 3,4,5 percent, on average, over the long term we think is quite deliverable. You know, I suspect next year will be okay. And it might be that ‘24 is going to be the year where, where life is a little bit more difficult for income. But, you know, again, we would expect - as we have been in the past - for the portfolio to be more resilient than the market by some margin.

Cherry: Okay, great. Rebecca, turning to you again, I wonder if we can look at a couple of the holdings in the portfolio. I believe. Taylor Wimpey and Unilever are both companies you've been you've been adding recently. Perhaps you could talk about those.

Rebecca: Yes, Taylor Wimpey is a new holding within the Trust. It's one of the large residential developers in the UK building over 14,000 new homes last year. So, this company is addressing what is a structural under supply of housing in the UK. And in addition, it's affordable housing division, which makes up about nearly 20% of its completions supports that area of the market. So, the shares have been - along with the broader housebuilding sector - have been very poor year to date, nearly halving in value in anticipation of what will be a slowdown in demand for new housing given mortgage rates have increased and the challenge around affordability. We are cognizant of these headwinds that the company is facing. But we think that the valuation provides an attractive entry point for the shares. The company has a strong order book. And it has a strong balance sheet with nearly 20% of its market cap held in cash, high margins and returns. And from an income perspective, it's 9% dividend yield is over two times covered. And the company has made strong commitments to continue distributing in the event of what could be a severe downturn. So, we think we're aware of these headwinds, and we think we're sort of cognizant of them. But we think the share price is pricing in quite a negative scenario, if we think if we're looking at the company on a three-to-five-year view.

The trust has been adding to our position in Unilever over the last couple of months is a well known household goods company, and we see it as an ESG leader. The company has demonstrated good pricing power in the recent inflationary environment with prices running over double digits. But we believe this is a testament to the investment that the company has made in its brand and in its product. There are some questions about the elasticity of demand going into next year given the price inflation, that we think the company should fare relatively well. And the profitability of the company should benefit in the event of some easing in the commodity price environment, which speaking to the company they are starting to see. So we think that the company should deliver some resilient earnings through what could be a tough couple of years for many companies and sectors. From an ESG perspective, we see it as an ESG leader, the company is exposed to material supply chain risks, and does face a fair amount of scrutiny. That said it has set ambitious targets around its own impact including a net zero target by 2030 and an ambition to half the amount of virgin plastic in its packaging by 2025. So we think this these are these are admirable targets and they also have the potential to support the company's pricing and competitive positioning as consumers become more environmentally focused going forward

Cherry: Great, okay, thanks. And then, just finally, Ben, I wonder, can you talk a bit about how the Trust uses the flexibility of the investment trust structure, you know, my instinct is that it should be really useful at a time like this, but perhaps you could talk about it in a bit more detail.

Ben: I think there are sort of three aspects, really to the investment trust structure that are that are really helpful and help differentiate the investment proposition from a traditional open-ended fund.

I think, firstly, is the ability to have gearing so we have some leverage within the portfolio. And I think at the end of the day over the long run, that's going to amplify our return. So, we have about 8% leverage. So if we, you know, lead to keep it simple, if over the long term markets deliver 7%, then perhaps, you know, having the sort of eight to 10% gearing can allow us to increase our returns by around 10%. So perhaps, you know, after costs, maybe we're able to generate an extra half percent or something of returns, which doesn't really sound like a great deal, but half percent over 7% is actually you know, quite a significant increase, and goes quite a long way to offsetting the cost of the portfolio.

The other angle that I think is also worth picking up is the ability of the board, I think, to hold the managers to account. So I think having that independent board, discussing, formulating strategy, debating, overseeing, really makes a big difference. And I think that's also something that that shouldn't be overlooked when considering the investment trust structure as well. 

And I think the other thing that's really important when it comes to income, is the ability of the company structure to be able to distribute consistently. So in the open ended structure, you're not really able to retain reserves, which means that the distribution is much more tied into the amount of income that you generate during that particular financial year, rather than within the closed end structure, you're able to basically put reserves aside on the balance sheet, both income reserves and capital reserves. And the company potentially can distribute those reserves in years where it doesn't have income that fully covers its dividend distribution and can use both income and capital to be able to do that.

And that puts the company in a very strong position to be able to consistently deliver income to investors and for investors aware that income distribution is important in terms of their financial planning, or were they relying on that to best supplement their income, then I think that's extremely useful that they can have a very high degree of confidence that dividends are going to be sustainable within an investment trust structure, because there's just that much more flexibility. So I think it's really those three things, the leverage that can increase in a prudent way and enhance and certainly offset costs, and modestly enhance returns. I think it's the board that ultimately holds investors to account and does the job of setting strategy and direction for the trust and an independent way looking after shareholders best interests, and then is the ability to consistently deliver income back to investors over time and I think it's those three things that really make the investment trust structure, very attractive for an income distributing fund.

Cherry: Great. Okay. Thank you. Well, we'll conclude there. So, thank you to Ben and Rebecca for those insights today and as always, you can find out more about the trust at www.dunedinincomegrowth.co.uk And thank you so much for tuning in.