Dunedin Income Growth Investment Trust: update from the managers

In this episode of the abrdn Investment Trusts podcast, we hear from the Trust managers, Ben Ritchie and Samantha Brownlee. They discuss some of the key issues facing the UK stock market today, and look at how that's influencing positioning on the Trust. 

Recorded on 22 March 2022.

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 Reynard, and with me today are the Trust managers, Ben Ritchie and Samantha Brownlee. We're here to chat through some of the key issues facing the UK stock market today, and look at how that's influencing positioning on the trust. 

So Ben, if we could start with you. The news has, of course been dominated by the horrible events unfolding in Eastern Europe. What do you see as the major impacts for the UK economy?

Ben: Clearly, there's been a hell of a lot going on. There was quite a lot going on before the Ukraine crisis developed. And I think in many ways, it just accentuates the challenges that were there before, really. 

So certainly, I think we can say that this is going to be even more inflationary and that inflation is likely to have a longer duration as a result of the impact on primarily on commodity prices, but also on supply chain. So, I think we can definitely say that. I think what we don't know yet is how that is going to impact on demand. And what that means for economic growth, I think we can surmise that it's going to make that more challenging, we don't know how that's going to transmit through.

 And then I think it raises a number of challenges for both governments and monetary policymakers in terms of how they respond to this, because I think, traditionally, you probably would have seen an easing bias from a monetary policy perspective, given where inflation is, and there's the desire, I think, to normalise monetary policy, that's become more difficult. 

And then from a fiscal perspective, you know, the government again, have been looking to tighten and looking to shore up public finances. And again, perhaps this is posing some challenges in the other direction. So I think it's a very interesting situation. From a markets perspective, it's obviously tragic from, from a human perspective. And I think there's an awful lot of things out there for us to be keeping our eye on. And I think, unfortunately, when we, when we wrap it all together, I'm not sure that anyone can really have any great insight into how these big sort of macros thematic elements are going to play out and think it does just bring us back down to, to the companies and hoping, as well as doing the best we can from an analytical perspective to invest in businesses that we think can cope with what's gonna be quite a challenging environment for all sorts of reasons, and probably some reasons that we haven't managed to think of yet. So we were fairly cautious coming into the year, this for completely different reasons, makes us remain fairly cautious overall, I'd say.

Cherry: Okay, thanks, Ben. And, Sam, are there any areas of the portfolio where you have cause for concern or where you're keeping a particularly close eye on things?

Sam: I think, broadly speaking, we generally look at things with a healthy dose of concern and scepticism, I think that's part of our job is to look out for these things. But having said that, when we do look across the portfolio, I think we are pleased to say that it's relatively balanced in terms of our exposures and where we sit is broadly the places where we want to be, we worry, obviously, as we discussed about logistics supply chains, working capital with cost inflation, the ability to, to price to offset that and maintain margins, cost efficiencies in other areas, and ultimately, how high demand will play out and whether or not we'd see that will result in some kind of temporary or longer kind of a recessionary environment. But when we think about the kind of companies that we invest in, we come back to the fundamentals and why we liked them in the first place, which were structural demand is strong in their markets with growth, they have pricing power, they have strong management teams, they have competitive, sustainable competitive advantages, and they have appropriate balance sheets with good cash flows. So I think broadly speaking, when we step back and say, are we in the right kind of companies I think we are, we just have to continue to constantly kick the tires when we meet management teams, and probe for areas that that do concern us and think about how management talk to us about that and how we put a sceptical eye over what they say and look through it through that lens. But I think broadly speaking, we're happy with where we're sitting. 

Cherry: And on a slightly more positive note, the latest economic data for the UK was actually pretty good and showed a strong rebound for the UK economy. Do any particular sectors or segments stand out Ben? 

Ben: I think consumption has rebounded faster than people have expected, I think, to some extent in what's happened in the Ukraine, does maybe make some of the economic data look a little backward looking really, in terms of what that means, what that means going forward. And some of the challenges that are going to be, that are going to be out there. 

I think we think we have a reasonable balance of exposures across the, across the portfolio. And I think the UK was doing okay, you know at least has some momentum coming into an environment that's going to be, that's going to be challenging. I think, we’d already expected and we don't, we don't have anything sort of particularly novel in this view. But it clearly we know that here with National Insurance increases and various other costs factors, from utility bills to various other things coming through that there was going to be some drag to consumption as we move through 2022, I guess, the impacts of Ukraine are only likely to intensify that element. 

And I think it will depend on a couple of offsets. And I think it's always very difficult to see exactly how these things are going to play out. So I think it's definitely right to be a little bit cautious. I think, on the other hand there were reasonable reasons to be quite cautious on what was going to happen when furlough ended. And that actually seemed to be something that was navigated with a relatively modest degree of impact on the overall economy. So always have to be a little cautious and how some of these things are going to play out. But we've been making some selective additions, where we think valuations have come back a long way. 

So, we've been adding to Persimmon, which has underperformed significantly, the largest UK housebuilder, I think that's a combination, perhaps of some concerns over rising interest rates, concerns over the impact of cladding on their business. But to our mind remains a good margin business, very, very strong balance sheet, very cash generative. Even if we do go into a more challenging environment, they're probably likely to be able to - maybe not maintain the existing very, very high dividend, but at least continue to distribute quite a lot of cash back to investors. And in over the long term, that seems like a reasonable option for us amongst the things which we can put capital into from a high yielding perspective. So that would be an example of one other area. And we've also been looking to try and pick up around the edges where we've seen some companies underperform quite sharply. So been looking to increase our exposure to things like Aveva in industrial software that's been kind of caught up with the sell off and more expensive companies that we've seen at the start of the year. So again, that seems like a stock that's good to increase our exposure to over time as well. 

And I think the other thing we've been doing this predates Ukraine, but I think we reflect a little bit of caution on our part, is really just looking, again, to put capital back into companies where we, as Sam was saying earlier, where we think there's good visibility, strong pricing, power, good margins, and should prove to be both resilient in a tough situation, but also able to make good progress in a in an okay, one. So that would be companies like Relx, companies like Assura, the owner of sort of GPS and primary care surgery. So it's been a mix of things for us looking to take advantages and opportunities. And at the same time, I think continuing to, I guess, kind of shore up the, the core of the portfolio and prepare for what might lay ahead.

Cherry: Ben mentions consumption there. If high inflation does prompt households to cut back in certain areas, do you think there are certain elements that are more vulnerable than others? I mean, consumer discretionary, and that sort of thing you’d assume? I mean, is there anywhere, you've kind of backed away from as a result?

Sam: Yeah, I mean, consumer discretionary, would be kind of the key one there that you would think as, as consumers begin to feel the pinch more. And you can obviously see that they do, then they would cut back on certain kinds of spending, I don't think that we generally would have high exposure to those kinds of areas anyway, we're not under, we're not mature, we're quite neutral on consumer discretionary. But the names that we have within that space, you know, are the stronger kind of ones as Ben mentioned, we added to Persimmon as that weakened. So we picked up more of that took advantage of kind of the market moves there. But there's other aspects of the market, which continue to see tough aspects, but don't necessarily sit in consumer discretionary and that some of these things the sector can, categorization can feel quite arbitrary once you actually kind of dig into what the companies do. 

So, the supermarket's, for example, they're sitting in the stable side they might see some weaknesses. We have exposure in kind of the stable side to companies that have more pricing power, but also more stable kinds of demand. Diagio is one of our biggest exposures there and spirits is a growing category. So, if people cut back, I still think they're going to enjoy a drink. And so those kinds of markets are okay. And then they can manage through cost inflation because of the mix of their, of their portfolio towards aged spirits. So, I don't think that we have necessarily cut back on exposures, because I don't think we had a lot of that going into it. So, it's more we look at what the markets doing. And we take a considered approach, we step back and we apply our long term process. And again, go back to the fundamentals of the businesses, and look for the strengths that we like and think, is the market understanding that in the long run, and can we take advantage of that? So I think that's more broadly what we've done.

Cherry: Ben, you talked a little bit there about some of the things you've been doing on the Trust this month? And is there anything else you'd highlight sort of new purchases, changes in gearing, and anything you've been selling, and that sort of thing?

Ben: I think it's sort of picked up a couple of things there, Cherry, that we've been up to, I think we're continuing to look to try and take advantage of where we do see some opportunities, I'd say, that's definitely a bit of what we're what we're doing, I think we're spending quite a lot of time, making sure that the portfolio as best we can, is going to be in robust shape if we do go into a more difficult environment. So that's been quite a lot of our quite a lot of our thinking as well. 

The events in Russia and Ukraine have certainly drawn our attention to a couple of holdings where they've got some, some exposure. So, Coca Cola Hellenic has got about 20% of its revenues coming from Russia and Ukraine. So that's clearly challenging for them. A company like Total, again, they've got quite a lot of revenues coming from Russia, to potentially around 10%. So those are things which we need to be on top of and understanding the risks that sit there. So, we've been pretty focused on that. 

And I think overall, I think yes, I think it's just been time spent trying to make some, you know, where we do decide to do things to make some meaningful differences to the portfolio. Again, keeping half an eye on the income account as well, looking to see if we can capture some attractive dividend yields. That's certainly been something that we've been, we've been focused on. And I think the other thing is continuing to concentrate the portfolio. So again, just asking ourselves, have we got the money in our best ideas? It sounds, it sounds obvious. But again, I think it's very important that we're not allowing ourselves to have too much capital tied up in investments where, we're relatively indifferent. So let's focus that, on the areas where we think we can get the best returns over the over the midterm from our investments, as you say, that sounds fairly obvious, but it isn't always the case - you need to keep focused on being disciplined on that, on that approach. 

So we're continuing to look at some of the smaller holdings in the portfolio asking ourselves are they still ones we want to hold and run with over the over the medium term. And if not, well, then we should be looking to recycle capital elsewhere. But it's interesting, I mean, there's quite a lot of companies performing pretty well, actually. So from an operational profit perspective generally speaking the portfolio is doing quite well, the first sort of month or two of this year have been tough from a relative performance perspective. But I think in terms of the underlying performance of the portfolios, holdings, generally doing quite well. And there haven't been any too many things that have been particularly tricky, you know, perhaps some of the Russian stuff to one side. So overall, we feel pretty good. But I'd say it's really focusing in on just making sure that we're as happy as we can be with what we've got.

Cherry: Okay. And you mentioned income there. Ben, I wonder if you can give us a sort of digest of the income position in the portfolio at the moment?

Ben: Yeah, income outlook for the for the Trust looks pretty healthy. We'll be reporting our full year results quite soon. Within that, we're certainly seeing earnings delivery ahead of our sort of internal expectations, really driven by a number of quite large, generous special distributions, which we received during the year from the likes of Rio Tinto. 

So, 2021/22, the income out of turn has actually looked, has actually come out quite a bit better than we had thought earlier in the year, certainly, with the original sort of effects of COVID. And as we move into this year, we'll have a couple of those things that won't repeat. So, we made some of the changes to the portfolio as a result of the SRI adoption. We won't be picking up some of the special dividends, which we got from the mining companies in the last year. But still, I think the underlying prospects look pretty good and we're really targeting, can we get the underlying portfolio growing its dividends in the sort of 4 to 5% range over time. Doesn't sound much but that'd be more than double, for the long term growth rate on the market has been over, you know, over the last 10 years. So if we can get something like that going, that's a pretty healthy level, we think as we emerge through this year into next, that's the kind of underlying earnings growth rate that we can get from the, from the dividends in the portfolio. And that should set the Trust up well, to be able over the longer term anyway, to be able to focus on its mission of delivering real growth in dividends. 

In the short term, that's probably going to be a bit tricky given where RPI and CPI are likely to turn out when this very high inflationary environment, and but over the mid to longer term, I think we'd still be comfortable at the portfolio in the position it's in, can deliver, can deliver something, you know, ahead of inflation as it has done over the long term.

Cherry: Sam turning to you. We've talked about the consumer segment there, I wonder if we could zero in on those consumer holdings in the portfolio? I mean, it's, as you said, it's sort of an under pressure segment, but are there defensive areas?

Sam: Yeah, absolutely. I think it is a big exposure and discretionary, and you put the kind of staples together. And we have certainly, as I mentioned before, Diageo, I think is quite a solid name, from that perspective, we also have exposure to Unilever. And we're actually whilst we're actually underweight Staples, if you break apart the sector in the market  almost 15% of the market in the oil share, but 13% of that, of that 15% is, is in six names, two of which are tobacco companies, which whilst you might think of as defensive when we look at the portfolio and how we how our investment process works with a quality lens and income lens, but also a sustainability and ESG lens, tobacco companies are not going to be where we're going to be sitting. So, we have solid exposure to what we think are the better businesses and better combinations within the market in that space. 

And then we also have exposure to, you would also think kind of almost consumer adjacent as these kind of thing with you have, we have an exposure to GlaxoSmithKline in the portfolio that has a consumer health business that they're, they're looking to spin off in the summer. We have exposure to companies that do animal health, which again is about the consumer, but then when you're thinking about the companion animal market, that is a spend that I don't think a lot of pet owners think of as very discretionary. We're also overweight to healthcare in general, which is a defensive kind of area. So I think our exposure in the consumer space is, is as we invest, would lend itself to being, a little bit more on the defensive side, as well as that has, comes with that income, which gives it a little bit of that protection at the same time.

Cherry: Now the Trust has an ESG focus, which we've talked about it in previous podcasts, but the rising oil price has obviously been the very public face of this crisis. Are there any areas of the portfolio that are being impacted by that? And I mean, Ben, you said you've moved away from mining, but does the Trust still own any oil stocks? 

Ben: Yeah, so I think the performance of the portfolio has been affected by I guess, the overall increase in commodity prices in a in a negative way in the last part of our financial year, so we don't have lots of exposure to that area for various reasons, down to the various pieces of our, of our SRI approach, and there are different reasons why different companies have been excluded, can be around corporate governance, can be about our own internal view of the company's ESG risk management, can also be around some of the screens which we deploy around the exposure to renewables and gas that we'd like to see from companies to be able to include them in the portfolio. So quite a lot of that segment has been excluded. And those companies, by and large, have performed pretty well, in recent times. So that's put a bit of pressure on the relative performance of the Trust. 

In terms of our holdings on the other side, I mean, I guess there's a hit to that - there's been rising inflationary pressures, rising discount rates have put some pressure on some of the higher valuation stocks which we have in the portfolio. So, we've had a number of companies where they've seen some quite chunky ratings over the last three or four months of our financial year to the end of January 22 - and I guess continued a bit into February 22. So that sort of combination, so it's affecting both what we what we don't own in terms of that performing well and then also effecting some of the things we do own and putting a bit of pressure on share prices. 

In terms of the impact on profitability, I think overall, we feel pretty relaxed about that. I think it as Sam's talked about, the margins in the portfolio a good, we're very focused on pricing power, brand equity, cyclicality, all those elements. So from a sort of impact of oil on company performance underlying, I think we're fairly relaxed about that, as it gets more the combination of impact on things we don't own. And then on the on the things we do own and the impact of multiples. But again, you know, we've seen a pretty big D rating, we've seen sort of average multiples in the portfolio come back quite a long way. So we would suggest that, you know, we've seen at least the bulk of that if not all of it.

In terms of our holdings, we do own one oil stock, we do own Total Energies in the portfolio. It's an interesting case study, I guess, in terms of well - how can you do that? In terms of our screens, we don't explicitly say we won't invest in oil companies, what we do say is we won’t invest in companies that get more than 10% of their revenues from unconventional gas. So, in that basis, Total has never had significant exposure to things like shale or tar sands. We also won’t invest in companies who were investing, net new capex in those areas. So again, Total doesn't have exposure  it's not caught by that. And then we're looking for businesses where they're generating at least 40% of their revenues in the oil and gas production businesses from natural gas and, and renewables. And that's really the area where Total scores well, versus its peer group, we think it - depending on exactly how you cut the numbers - but it's got probably around 50% plus, by volume of its, of its production is coming from gas. And by value, it's a little bit over 40%. And it's the 40% that we use as a threshold. 

But I think it's also important to say that Total has also got some other some other assets as well, I think that that are worth considering. So, it does have a very big LNG business as well, it's going to be pretty critical in terms of at least transitioning the sort of energy dynamic from fossil to renewable over time. And then it also has a very sizable renewables business. So, in terms of its installed base of renewables, it's got about 10 gigawatt hours of electricity production from renewables. That's not a, that's not an inconsiderable amount. In fact, it's not that much less than a company like Orsted has, I think it was about 12. So the size of Totals renewables businesses actually is actually quite significant. And when we look at the contribution to revenues that that makes, and then look at the contribution that they're that they're generating from natural gas, then it will be put that all together meets the threshold.

Now, absolutely, I think it's one of the things where we've also got to say, well it may meet the threshold, but does it meet the spirit of what we're, what we're trying to do. And I think we know that there's an important role for energy companies in the energy transition. And we think that Total is a leader in that space, we certainly wouldn't try to tell you that it was one of the sort of sustainable leader in an absolute sense, but we would very much see it as what we would call a sustainable improver. So, we do think that there's plenty of scope for Total to improve what it's doing, that we think it meets the threshold tests which we apply, going forward we'll be engaging with the company to continue to push that agenda. 

And I think when we look at some of that sort of third party assessment of Total, and how it, how it's delivering, if we look at things like the sort of transition pathway initiative they see Total as one of any three oil and gas companies globally, which they think are on track to sort of with a set of policies that can help meet the one and a half degree initiative. So Total within its industry, we see definitely, as a leader within the market, we'd probably say yes, actually, its average, but overall, with scope to improve and play a bigger role, and then it's going to continue to be investing pretty substantially in renewables as well. So, I think up to 20% of their capex is going to be going into that space from the middle of this decade. I think it's about 15% at the moment, so we're going to be continuing to see strong growth on that part of their, of their business as well. So, it's one of those ones where it's a slightly controversial holding, perhaps, but we think overall, it's justified both from an interpretation of the rules but also from the important element it's going to play in terms of transition going forward.

Cherry: Great, okay. Thank you, Ben and thank you, Sam, as well for those insights today. You can find out more about the Trust at www.Dunedinincomegrowth.co.uk, and thank you to everyone for tuning in.