Dunedin Income Growth Investment Trust manager update: Ben Ritchie and Rebecca Maclean - December 2022

In this latest episode of the abrdn Investment Trusts podcast, Dunedin Income Growth Investment Trust managers Ben Ritchie and Rebecca Maclean look back on an eclectic 2022, and consider what 2023 could have in store for investors. 

For more information: www.dunedinincomegrowth.co.uk

Transcript

Cherry Reynard: Hello and welcome to today's podcast on the Dunedin Income Growth Investment Trust. I'm Cherry Renard, and with me today the Trust managers, Ben Ritchie and Rebecca Maclean. We're going to be taking a look back on an eclectic year and asking whether 2023 holds better prospects. So welcome, Ben, welcome, Rebecca. 

Ben, if we could start with you. There's been a lot for markets to process this year. Let's start with the inflation and interest rate environment, so where did we start the year and kind of where did we finish?

Ben: Well, certainly, we've seen a much more inflationary environment over the course of 2022 than people expected at the start of it. And interest rate expectations have also increased significantly over the course of the year from the beginning of January through to the end of the year as well. So, there's been a marked shift in that. I think inflation expectations long term, have probably not moved up that much. I think that's an important thing, that the sort of long-term inflation expectations of people in the UK and around the world, if we're looking at the surveys, haven't significantly increased - I think that's important in terms of anchoring expectations. But we've clearly see a very high near term inflation numbers, I think, CPI, RPI, you know, 13, 14% in October, so very, very high levels, the highest levels we've seen, certainly in the early 1980s. 

Looking forward, you know, who knows how those evolve. And we suspect that we've seen the worst of it from an inflationary perspective. But I think the key thing, then is how, how quickly does it subside? And it doesn't get embedded into wages and therefore becomes a more sticky part of core CPI, I guess is the, is the kind of key question. And we'll have to see where that where that leads us to. 

Again, interest rates have moved up very sharply over the course of the year. And we certainly seen bond yields spike around the time of the sort of disastrous mini budget. Since then, the longer term bond yields have come back quite a long way. But we're still relatively elevated as well. So there's certainly been a marked increase since the start of the year. And if you know, if you go back to, if you go back to the start of 2021, I think the expectations in the United States for interest rate increases in 2022 were very, very modest indeed. So, to have seen that, you know, the Fed raising interest rates by 75 basis points at a time has been, has been quite a turnaround. So, you know, we'll have to see. I suspect we're, we're closer to the end of the beginning of the tightening cycle and inflation is likely to moderate. But I think the key thing really is where does it, where does it level out? And that's probably the big, the big question for ‘23 and beyond.

Cherry: Great. Okay. Thank you. And, Rebecca, can you talk a bit about the impact on the UK stock market and how those big trends have been felt?

Rebecca: Certainly, so the FTSE all share, which is the benchmark is broadly flat year to date, but it has been volatile and the domestic focused FTSE 250 is down 20% year to date. So we've seen a disconnect between the larger cap FTSE 100 companies, which tend to be more defensive and energy exposed sectors, outperforming the domestically focused FTSE 250. 

The energy sector has been the standout performer with the sector up 45% year to date, the healthcare sector and utilities consumer staples sectors are broadly flat to up, and the worst performing sectors have been the more UK domestic cyclical sectors like the real estate sector, which is down 30% and the consumer discretionary sector, the IT sector, both of which are down close to 20%. We’ve seen the market derate in anticipation of a slowdown. So the market has derated about 20% this year, and we've seen quite a sharp style rotation, but most notably that happened at the start of the year. But through the year we've seen the value style outperform quality and growth.

Cherry: Okay, great. And then Ben, how have you managed this environment in the trust?

Ben: It’s really been a kind of a year of two halves, I think overall. I think the first half of the year, particularly the calendar year was very difficult from a, from a relative and absolute performance perspective. And I think our main focus during that time was really just to focus on the companies which we really like in the portfolio and continue to add to them, so there were no additions to the portfolio during the first half of our financial year and the first seven months of the year. And we just continue to slim down the number of holdings and recycle that capital back into existing holdings where we had increasing confidence either because of changes at the business level, or because the valuations that become much more attractive. So we exited out of things like Glaxo and Halion and added capital to things like Unilever, and added money to things that were underperforming such as Avabor and London Stock Exchange and other companies in that area, and you know, some pretty good, good quality businesses with good long term growth that had been sold down in the sort of bond yield driven rotation in the first part of the year. 

And the second half of the year, Rebecca and I have been looking, continuing to look hard for new opportunities. We have a long list of what we call our watch list of potential adds to the portfolio, but we still very much like what we what we have. And what we're really looking to do is create tension for capital. And it's having those good new strong ideas that can allow us ultimately to improve the total return and income growth prospects for the portfolio as we sort of move on from some things and rotate capital into better ideas. But we tend to do that in a fairly, in a fairly modest way. 

So additions to the portfolio in the second half have been switching out of Persimmon and adding Taylor Wimpey so not a different sector, but we added more capital into Taylor Wimpey than we had in Persimmon, so we increased our position overall. And we just felt that Taylor Wimpey was better positioned or hadn't been stretched so much in terms of its margins, has a very, very strong balance sheet, and we thought was more likely to maintain its ordinary dividend. And in more recent times, we've been looking to add companies like Hiscox, the Lloyds insurer, and also general insurance business in North America, and also added Oxford Instruments as well, which is a specialist industrial manufacturer of high tech scientific equipment. So we have been adding new names. But it's the first half, as I say very much focused on what we have the second half are looking for some of the opportunities and I think as Rebecca said, it's been those domestic cyclicals as well, that have been really hit hard over the course of the year. And that's really where we've been adding capital to mainly to things we already own. But we've been adding capital to things like Morgan Sindall, Marshalls, adding more to Taylor Wimpey and that’s really been as a result of the decline in the share prices and what we think are quite attractive valuations for the, for the longer term, although clearly it's going to be a bumpy ride over the next few months.

Cherry: Rebecca. Ben mentioned the mini budget there. And it's obviously been a difficult political year in the UK to say the least. Do you think we're kind of through the worst on that and has sentiment towards the UK market improved?

Rebecca: Yes, I'd highlight the peak uncertainty around the political environment to be around the mini budget towards the end of September, and then the period from there until the autumn statement, I think there was still a degree of uncertainty. But as we got more clarity around the government situation, that improved. And I'd say that since the new government has been in place and issued its autumn statement in November, the political situation has stabilized, I give some examples. 

So the UK utility sector is a sector which is very sensitive to political uncertainty. And peak uncertainty was around the mini budget and concerned around potential windfall tax for that sector. And we do have exposure to that sector, we hold SSE the utility company. But what we saw from the autumn statement, the chancellor has now set out what the energy windfall tax will be for the sector. And that has removed an overhang and provided clarity on that sector which has been welcomed by the market. They putting a an excess levy of 45% on excess profits above 75 pounds per megawatt hour, which is probably slightly better than the market was expecting. But the market really feels reassured knowing that, that is the level and can go and look forward now into modelling future profitability of the sector with more clarity given that political overhang has been removed.

Cherry:  Ben, it feels a bit unfair to be asking you to make predictions for 2023, when everything feels very uncertain. But there has been some speculation that we might start to move from an environment focused so, you know minutely on interest rates and inflation to one more focused on the relative risks of individual companies. I mean, can you see that happening? 

Ben: It's likely that we're gonna have less intensive focus on interest rates, because I think they're going to get to a point, so where the expectations are probably more balanced today than they than they were at the start of the year. And I think the sort of look forward is, I think, to some degree clearer in terms of the direction of interest rates and where the where the market is expecting them to go. And I think for 2023, that looks a little bit more, a little bit more settled. So, providing we see inflation start to moderate the interest rate dynamic develop as people broadly expect, then I think we will start to see more focus on company specifics. I hesitate to say, company fundamentals, because I think kind of company fundamentals are normally being assessed by market participants. But there has been an unusually high emphasis on the macroeconomics, and it's rarely been the case, in my career, that there's been such intense focus on every piece of inflation data, particular from the United States, and every word that's coming from the Federal Reserve Chairman. So I think, you know, as investors in companies, I think we welcome a more focus on the businesses and what they're delivering. And, and to be honest, that's what we spend our time really worrying about. So, you know, when we look at the portfolio, the things we get concerned about, where the businesses aren't performing from a, from a revenue, profit, cash flow, and dividend perspective, and you know, there are a couple of those in the portfolio, that's where we spend our time, primarily focusing - we spend less time in worrying about share prices, I mean, that that's clearly part of it. But we don't spend a huge amount of time worrying about that, if we think the fundamentals of the business are fine, and the business is performing well. And then I suppose the other thing, then is the sort of broader market sentiment and macro elements, which again, you know, we are aware of, but we don't spend too much time thinking about because at the end of the day, they tend to be things that are, you know, somewhat unpredictable, rather than we feel we have more of an edge when it comes to looking at the future prospects for individual  companies. So long way of saying very hopeful that we spend less time talking about inflation and more time talking about profits in 2023.

Cherry: Okay, thanks. And Rebecca, do you have a central case for 2023? I mean, are you expecting a severe downturn or something a little milder? 

Rebecca: I think there's a range of outcomes, and it will depend on the market and the individual sub sector. So I'd say that we probably are cautious on the UK consumer, as we look into 2023, given the cost of living, higher mortgage rates, and interest costs, could put a squeeze on some discretionary spend there. Similarly, global PMIs are negative and so, some of the more cyclical sectors, for example, the industrials, had seen that earnings remain relatively resilient this year. But looking at next year, there probably is some optimism within forecasts so we're looking sort of closely at the earnings expectations within those cyclical sectors to see how they're going to perform next year. 

But there are pockets of optimism. So looking at the US, the inflation Reduction Act is going to support sectors including energy, renewables and health care. And that could lead to stimulus and support for those sectors. In addition, we're hearing from companies that the nearshoring trend could benefit UK and European companies. And so we're looking to see how companies in our portfolio are positioned in terms of the headwinds and tailwinds which those trends present. But I think taking a step back, you know, we've got a quality approach, and we're looking for companies that can generate cash flows through the cycle. And we think that if we do head into a downturn, though, companies which are providing essential products and services with strong competitive positions and resilient financials should be well placed to navigate what could be an uncertain economic period.

Cherry: And finally, Ben, if I could just get a few words from you on how DIGIT is positioned today, you know, any notable themes running through the portfolio?

Ben: We think we're overall pretty well balanced. You know, again, we're sort of dealing with a pretty uncertain environment. And we want to be able to participate in a range of different market environments, we think we should be fairly resilient. If we go into a really tricky, or even more tricky economic environment, we think that the earnings power of our companies should be better than the market and the balance sheet should be, should be more robust. So we would expect the portfolio to be to be more resilient in that environment - it’s what we've seen in the past, and it's what we would expect in the future. But equally if we do see investors becoming more confident, and more enthused, you know, we do have and have been increasing our exposure to some of those UK mid cap or smaller, smaller large cap domestically focused businesses that we would hope that we can participate in that. So, I think overall, trying to strike the right balance, really, if we can have a year where, on the income side where we're growing sort of mid-single digits, that would be I think that would be pretty good in the environment. If we, if we can do that with the right kind of companies, then I know, hopefully, overall, we'll be able to deliver a satisfactory outcome to investors. And we'll just be very, very focused on making sure the companies are delivering and if we get that bit right, then, you know, hopefully share prices will follow and everything else will fall into place.

Cherry: Great. Okay. Well wrap up there. Thank you so much, Ben. And Rebecca, for those insights today. As always, you can find out more about the trust at www.dunedinincomegrowth.co.uk. And thank you so much for joining us.