Dunedin Income Growth Investment Trust manager update with Ben Ritchie

In this episode of the abrdn Investment Trusts podcast we are joined by Ben Ritchie, co-manager of Dunedin Income Growth Investment Trust. Ben discusses the latest news relating to the UK economy, and provides an update on the Trust's positioning. 

Capital at risk. 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 is manager on the Trust Ben Ritchie. We're going to be looking at the latest updates on the UK economy and discussing what's happening on the Trust. So welcome, Ben. 

Let's start with a look at what's been happening in the UK over the past month. I mean, what really stands out was the inflation data which was ahead of expectations. I mean, what's your interpretation of the latest statistics? Is there anything that's worrying you in there?

Ben: Well, thanks Cherry, thanks for giving me the opportunity to sort of talk on all things all things DIGIT today. So, I guess the UK inflation data was quite a lot higher than expectations. And it remains it remains very elevated, and well above the Bank of England's sort of target range. I think the key thing though, is looking forward is how, how some of the sort of forward looking elements are going to come together around this. So we know that we're quite likely to see input prices fall, we're going to see gas and electricity prices fall over the second half of the year, we're going to start to see food price inflation ease, we're starting to annualise a lot of the effects that came through from the Ukraine crisis. So we've got all of those things ahead of us. Certainly, the situation today is difficult. 

And I guess the other thing that's developed over the last few weeks has been the increasing stress in the banking system. So no real sign of that so far among the UK banks. But certainly we've seen stress and pressure among a number of American banks. And of course, we've seen the effective collapse of Credit Suisse, as well, both of which I think will be bringing concern to the attention for the Bank of England and will have played a role in their consideration around monetary policy decisions. So I think, yes, inflation high today, but I think there are some reasons on the horizon, why it should be heading in the right direction relatively soon and why there are also some, you know, other economic concerns floating around that we need to keep an eye on.

Cherry: And I mean, the other big thing was obviously, the Brexit deal, which has now just gone through Parliament, rather easier, I think, than somewhat anticipated. I mean, does that make any difference for UK companies for the companies in the portfolio?

Ben: I think big companies are generally pretty adept at managing the regulations, I certainly think the Brexit situation will have, will have raised costs for companies exporting from the UK to Europe and importing from Europe to the UK to some degree. But I think, you know, for large PLCs, the friction costs have probably been manageable overall if they exist, but that they'd be manageable. It's probably been at the sort of SME level where the companies have found entire business lines effectively ruled out as a result of some of the changes. But undoubtedly, it's elevated, it's elevated trade costs. And I think probably the other area where it's made a difference has been around labour markets, where clearly, I think, the combination of COVID and then the impact of Brexit combined have made some major impacts on the tightness of the UK labour market, which is definitely affecting company profitability, and flexibility in terms of their ability to manage their business. So those things are real. What does that mean around the Northern Ireland protocol and the deal that's been announced there? Well, I think it's an easing of tensions, which can't be unhelpful. I think on its own, is it a big deal? Probably not. But I think it certainly signals a bit of rapprochement between the EU and the UK. I think it signals that the UK can do deals with the EU. I think it also potentially opens up the opportunity for the UK to pursue trade deals with the US that would have been very difficult to do if we weren't in a coherent position over Northern Ireland and its borders. So I think a number of positives, I think overall, you know, they’re sort of at the edges, possibly helpful for sentiment for the UK economy overall. I don't think it's a, it's a game changer, but it's moving things in the, in the right direction.

Cherry: Okay, and the final thing is, the housing market has looked quite wobbly over recent months. I know you hold some house builders in the portfolio, is that a worry?

Ben: Well, I think it all goes back to the autumn time where you saw sort of two year yields, which I guess will probably be a typical funding rate for, for mortgages in the UK - go from a couple of percent, you know, I think we've got up to 6% at one point. And I think the mark still hasn't come all the way back down, it's sort of still 4.2, 4.3%. So, I think that's reflecting, yes, elevated levels of inflation, but also the impact on competence from the Truss-Kwartang budget. So those things and if you imagine, you know, effectively a tripling of financing costs for people that want to take out a mortgage, that's clearly gonna have an impact on sentiment. 

But I think, you know, we have started to see some early signs that that's improving. I mean, we saw activity for house builders in the fourth quarter really collapse from buyers and interest. That's slowly picked up and improved as we've moved through 2023. It's not got back to where it was, but it's been improving. And prices, I guess, have been relatively stable. I guess it depends what survey you look at. Some suggest that asking prices have gone down a little bit, some suggest asking prices are up a little bit. 

I think as far as that affects companies in the portfolio? Well, I don't think the level of volume of production of houses was very high, prior to the autumn. So, we would say that there's probably a natural level of supply that needs to come back into the marketplace. And that supports companies in the construction space, like Marshalls, for example, or, to a lesser degree, something like Morgan Sindall. And then it's the house builders themselves. Well, I guess, you know, multiples collapsed, really in the autumn, they've moved up somewhat since then, you know, we would see a steady and improving trend, if asking prices are relatively stable, perhaps you're starting to see a little bit of build cost, inflation ease, and we've certainly heard about that from some of the other house builders. And if we're starting to see sales rates pick up then I don't think that's a terrible, a terrible backdrop for, for the house builders. And if anything, I think sales rates are probably going to be the key delta, really for improving their financial performance. So if prices are up or down by a percent or two, I don't think that really makes a big difference for them. 

But actually, getting sales backup to previous levels will be the, will be the key thing. And I would say there, there's probably a few signs of optimism, although, again, with the recent shudders in the banking system, you know, we maybe watch and wait around that. But at the moment, that looks like that's improving somewhat, and then we're moving into the key spring selling season. So, we'll see how that evolves.

Cherry: The other macro-economic issue is perhaps more of a global one. I mean, you've got on the one hand, you're seeing this sort of deglobalisation trend and sort of supply chain shifts. But on the other hand, you're seeing some unclogging of supply chains in kind of the wake of the pandemic. I wonder what the sort of net effect is for companies in the portfolio?

Ben: I'm fairly cynical on this deglobalisation idea, I’m not sure there's a lot of data that supports it to be honest. If you look at global trade levels, they've been around these levels for about the last 10 or 15 years. So I think what has changed is, who's trading with who, and where corporates are locating their manufacturing resources. But I think to suggest that suddenly, you know, where those manufacturing is being relocated back to, I don't know, the north of England or wherever else it might be. I just don't, I don't think there's any evidence to suggest that that's happening. I think what we have seen is companies looking to diversify their supply chains, I think that's as a result of COVID. They’ve realised that having, you know, one point of manufacturing in one place can be extremely risky. So they've looked to diversify their, their supply chains. I think there's another element, which is the people that look to become less reliant on China - I think A: has become more expensive to manufacture there and B: I think they're cognizant of the political risk, and so they'd look to move to other places, particularly in Southeast Asia. And I think there's also another piece where companies are making strategic decisions about nearshoring. So perhaps bringing some of their supply chain a little bit, a little bit closer to home, for reasons perhaps around strategic flexibility. And then also, I think, becoming increasingly aware of their, of their carbon footprint and wanting to minimise that as well. So there are a number of dynamics going on there. But I think in terms of the overall volume of global trade, is that shifting in a dramatic way? I'm not so sure it is, I think the way in which it's moving around has changed. But I'm not so sure that globalisation is dead just yet.

Cherry: Yeh, certainly, the deglobalisation indices just show a sort of tiny little blip in a kind of 20,30-year trend, it's quite interesting. Now, if we could turn to the portfolio. I wonder if you can talk about some of the recent results you've seen? What are they telling us about the health of UK PLC? And is that any different from the story we're getting globally?

Ben: I think overall, you know, the UK markets results that we've seen through the first sort of three months of the year have been pretty positive. You know, we've had the odd company that's had some issues, but they've largely been, you know, kind of either very idiosyncratic or, or self-inflicted. And I would say that, generally speaking, overall, the outlook has been quite reasonable. So if you think about the sort of three major kind of areas that companies are operating in, and we think about Europe and UK, think about the US, think about Asia or China, you know, the US consumers continue to be relatively robust. So there was a little bit of a wobble, say around Diageo’s results. But actually, they would say that their sell outlets to customers has remained robust. So the US consumer for now continues to be in relatively decent fettle. So that's been positive. 

In Europe, in the UK, you know, lots of concerns about industrial gas shortages, you know, that we'd have blackouts, etc, etc. And none of that's come to pass. The UK and Europe have managed their energy crisis or managed their way out of the energy crisis. And the economy in the both the Europe and the UK is doing a little bit better than people had expected at the autumn time. So that's generally been reasonably positive. And I think when we think about the UK consumer, you know, they continue to be in relatively okay shape. 

We mentioned house prices earlier, but I mean, the UK retail sales out today that were well ahead of expectations - now that’s perhaps coming from a low level - but the UK consumer remains relatively robust. And then if we think about Asia, and China, I mean, I guess the big, the big thing that's changed is the reopening of China, and the relaxation of its COVID restrictions. And that clearly has meant and will mean that there's going to be a big pickup in domestic consumption of China. And that's going to be good news for companies that are exporting into those markets. I think the other element, and you touched on this earlier, Cherry is that what we've seen is quite a significant easing of supply chain constraints. So again, in terms of costs for companies and friction and cost to end consumer, you know, we've seen a big easing in supply chain constraints, we've also seen big drops and things like shipping prices, we continue to see very large reductions in the price of natural gas. And that will be through into electricity prices, and ultimately through into electricity bills and utility bills in a somewhat delayed fashion. And all of that feeds through into lower costs for businesses. So I think, while the outlook certainly isn't buoyant. And again, we're starting to get some concerns around this monetary policy tightening and what that's done to the banking system. But I think overall, while the economic backdrop for corporates isn't fantastic, it's actually proved to be a little bit better than people had expected. And I think as a result, that's fed through into better out turn from company results in the first quarter of the year. And generally speaking, you know, we've been pretty happy both with what we've seen from earnings, and from a dividend perspective. 

Cherry: Okay, that's encouraging. This is a slightly longer term question. But over the past month, we've seen, you know, a couple of, couple of things where companies are planning to sort of leave behind their UK listing - listing in New York or, or that sort of thing. Is there any worries about diminishing choice in the UK market? I know you can invest sort of 20% of the funds overseas, but does that bother you at all?

Ben: I think the relisting thing is interesting. I mean, if you go back 20 years ago, the dual listings ADR programmes were quite popular options for companies who were looking to try and take advantage of the fact that in their sector in the United States, companies would generally trade on a high multiple. I don't think those moves were particularly successful. I think for a company to change its primary listing is a big deal. It basically leaves behind one group of shareholders and then as to go and find an entirely new cohort of investors in another market. 

If we look at certain sectors, it's clear that some companies have been more highly rewarded in the US than their European counterparts and they have high multiples. We've seen companies like CRH building materials business announce that it's going to relist there and that's benefited the share price as a result. So, I suspect, you know, where you do see that arbitrage, delivering significant uplifts in shareholder value, then you may well see companies pursue that. 

I guess the other side to it. And this is probably unfortunate, but I think another thing that companies and boards and management probably think about some degree is that the US does tend to be less restrictive from a governance perspective. And also, pay tends to be a lot higher for executives. So, you know, that sort of triple whammy of getting a big uplift in the share price, having to deal with less governance regulation, and then potentially having higher levels of financial reward is potentially quite attractive. Now, they've obviously got to persuade their shareholder base, that that's the right thing to do. And in certain cases, you know, perhaps it doesn't make sense. I'm not sure that that's the sort of panacea for all company ills that it seems to be floated as. 

In terms of choice, I guess, we've seen de-equitisation, I guess, has been a theme, you know, we've seen more capital held in private markets, we've seen the number of listed companies contract globally, and to some degree in the UK as well over time. And that does reduce choice. And I think one of the great things about DIGIT having the capacity to invest overseas, that 20% is actually so much more important than just 20%. Because while that doesn't sound like a great deal, by opening up Europe as a potential area, it sort of really triples the number of companies that we can consider for the portfolio, which in terms of the, I guess, if you think about the sort of palette of options for us to be able to deploy within the portfolio, then we've got a lot more choice as a result of that. And that's really, really helpful. So I don't feel constrained at all, really, in terms of, of options for building the portfolio. It's always a shame when things get taken over, as particularly if you don't feel you're getting a great price for them. And that's happened a couple of times. In the last financial year, we had a AVEVA and Euromoney both taken over, both really good companies, both where we felt that the prices of the bids were fairly unexciting for the long-term prospects. And so yes, short term win, but long term, you miss out - so we do take that  view on these things. So overall, I don't see the re-listings as sort of - it's a theme. It'll be around. I'm sure there'll be some companies that will pursue that path, but it's not an easy one, necessarily. And then at the same time, I still see plenty of opportunities for us.

Cherry: Okay, great, interesting. Just finally, in 2022, there was this huge split between small caps and large caps in the UK - with small caps doing badly and large caps doing well. I'm wondering if that's sort of reversed at all, since the start of the year. And, you know, what does that look like in the portfolio? What's the, what's the market cap split at the moment? 

Ben: Yeah, so it’s a, it’s a great question. We certainly saw a good performance from smaller mid-caps during the final three months of our financial year, which was November, December and January where they really sort of actually outperformed and I think that was coming back to this a bit of recovery and confidence in the domestic UK economy in small and mid-caps are always more exposed to the domestic economy. So that was, I think, helpful. 

We've got about 30% of the portfolio invested in this sort of mid cap space, small cap space. So a decent overweight. And, you know, we always think that that sort of market cap space of say, a billion to 10, maybe up to 20 is sort of, you know, the most interesting part of the market, probably it's not to say that you can't make great money out of big companies. But I think that there's a nice balance in those mid-sized businesses where the company has lots of runway for growth and is the sort of law of smaller numbers, I think gives you potential for bigger, for bigger upside. So, you know, we're always quite enthused about that and I think gives us the opportunity to find interesting things, leverage our good research, and do things a little bit differently to some of our competitors as well, not just for the point of being different, but because we think that there are some really attractive opportunities out there. And I think when you look at DIGITs top 10 Holdings, I think they are pretty different to  a lot of our competitors.

Cherry: Great. Okay. Thank you, Ben, we'll wrap up there, a great round of insights today. As always, you can find out more about the trust at www.dunedinincomegrowth.co.uk. Thank you all once again, for tuning in.