Dunedin Income Growth Investment Trust : Update from the managers

In this episode of the abrdn Investment Trusts podcast we are joined by Ben Ritchie, and Rebecca McClean managers of Dunedin Income Growth Investment Trust. They discuss the latest news relating to currency interest rates and energy prices .

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 are the Trust managers, Ben Ritchie and Rebecca McLean. We're going to be talking about currency interest rates and energy prices. So welcome, Ben. Welcome, Rebecca. 

Ben, I wonder if we could kick off by talking about interest rates - yet again. It's been a very busy week for central bank meetings. And in the UK, some commentators seem to think that 6% rates is a real possibility now, do you think that's likely? And would that be a concern?

Ben: Yeah, thanks very much, Cherry, I think we've seen a pretty hawkish week, I guess, overall, we've seen the Fed pause, but certainly increase their expectations as to where they see interest rates going over the coming months. And we've seen the ECB raise interest rates by 25 basis points and again, signal firmly that they're going to continue an upward path on interest rates. 

And I guess, while the UK Bank of England doesn't meet until next week, we've seen two year yields move up very substantially. And then out above where they were, back in October, when we had the sort of, you know, the Truss- Kwasi Kwarteng debacle. So I think, you know, we've seen a sort of quite sharpening of expectations on interest rates. And I think that's really coming back in the UK’s case to the tightness of the labour market, there was some strong employment data and wage data that came out during the week. And I think that's continued to put upward pressure on inflation expectations, and as a result on interest rate expectations. 

I think there are a number of things, though, that are coming towards us that may take some of the pressure off. Firstly, we should start to see energy prices fall. And that will start to come through as the various mechanisms for assessing these things kick in over the second half of the year. So that will come through and will take some of the pressure off. I think the other side is that you are going to start to see the impact of higher interest rates on mortgage borrowers. And we had a large number of, of mortgages that were taken on from 2020, 2021 with stamp duty cuts, and largely on two, three year fixed rates, and those will be rolling off over the next 6 to 12 months. And I think we will start to see that affecting the economy. And I think the structure of the mortgage book in the UK is different to how it was in the past. There’s not lots of really long dated mortgages, you know, you don't have the 25 year mortgage type situation. But you do have, you know, more twos and threes and fives than you did in the past when a lot of people would have been on spot rates. And I think as a result, we will start to see that coming through. So that will, I think, deliver some of the dampening to the economy and to inflationary pressures that the Bank of England is looking to see. 

If we look at forward markets, you know, they're expecting interest rates to peak at 5.75%, something like that. So expecting, you know, close to more, you know, over 100 basis points of additional hikes. I think we'll just have to see how that, how that all comes into play. Because interest rates do go with the lag, looking at current data and assessing what you should be doing on interest rates is, you know, those, those two things don't necessarily correlate. And so I think, you know, let's see. We've seen quite a tightening and will no doubt probably see at least another couple of interest rate increases in the UK. But I think whether we get to five, or whether we get to six probably depends on how we start to see the data evolving in the in the second half of the year. 

Cherry: Okay, so watch and wait. The secondary effect of the anticipation of higher interest rates has been to drive Sterling higher, I mean, which companies are likely to be most affected by that, and in particular, could it exert a drag on dividends, you know, certainly in the translation effect from US dollar earners?

Ben: There are sort of two elements really always to consider, and one is translation, which is essentially, you know, how much of your revenues are coming in foreign currency. And then obviously, they're affected by the value of Sterling versus Dollar and Euro and Yen and other global currencies. And then there's the transactional element and the transactional element is the difference between your costs and your revenues in terms of FX. So, from a translation perspective, you know, as we talk about often on this program, around 70% of the revenues of the UK market are coming from overseas so stronger Sterling, all things being equal is a negative for UK revenues and profits within the stock market. So it's not dramatic, but you know, roughly for every 1% increase in sterling against a basket of currencies, it's going to reduce revenues and, and by around 0.7%. So that's the sort of border of magnitude that comes into play. So, you know, it will be a headwind. But it's not at this stage dramatic. 

I think the other thing you've then got is companies that pay their dividends in Dollars as well. So, to some extent, they could see an impact on their business. And then, you know, the Sterling value of those Dollar dividends is also being, you know, constrained by the strength of Sterling. So that's also an additional headwind that comes into play. And you've got some pretty large Dollar payers in the wider market as well. Although, you know, when we look at the book overall, you know, I think about 70% of our revenues, maybe a bit more coming in Sterling. So we’re not too exposed in that regard. 

And then I think, the thing that which you need to watch, because the impact can be much more significant - is on transaction of exposures. And that's really where companies say are earning revenues in Dollars, but they've got their costs in Sterling. That doesn't tend to happen too much. But there are some companies that do have that type of positioning, particularly exporters, that are manufacturing in the UK, that can put some pressure on margins, they do tend to have hedging and various other things. But that's definitely the case, and there are some companies which may be exposed to that. But I don't think that's something that's dramatic. 

But of the offset of that, you know, there are also companies that buy a lot of product in Dollars using and have Sterling revenue. So, most retailers in the UK market are pretty much buying - they're buying whatever it is that they're selling in Dollars, and then selling it in Sterling. And so stronger Sterling overall is probably pretty helpful for our retailers. And you know, and there should also potentially be some, you know, benefits from an inflationary effect from stronger Sterling, if we're importing a lot of food or whatever else it might be. And it's and it's going to be cheaper coming through in Sterling terms. And that also might be a mild benefit. So overall, I would say it's, you know, net for the market. It's a modest headwind, I would say headwind for income as well at the margins, not something that which we're overly concerned with at this point. But there are also some companies which will, which will benefit as well. But it doesn't tend to be something which we look to try and play. It is just what it is. We want to avoid the risks of big transactional exposures generally. But we don't tend to spend too much time worrying about as I generally think over time, it sort of washes itself out.

Cherry: Okay, great. Thank you. Rebecca, turning to you if we can, one of the big recruitment companies had a profits warning yesterday. And I was just wondering, are there certain sectors that kind of end up being the canary in the coal mine for UK markets, you know, that give an indication of the of travel for the UK economy? Anywhere you're looking at in particular? 

Rebecca: Yeah, I think you're right. We are seeing pockets of weakness. And there are certain sectors which demonstrate evidence, earlier on in a cycle of a downturn than others. And the recruiters is one sector that you mentioned, so Robert Walters had a profit warning this week, they're still seeing strong pipeline for jobs and wages are holding up, but they are seeing delays to hiring, driven by consumer confidence and some of their exposures by region and sector. So it is a bellwether, the company had to – given it's got high level of operating leverage, downgraded to profit expectations meaningfully. And the company is now trading close to trough multiples on close to trough revenues. So certainly, it feels that for the sector, we're getting close toward peak negativity in that sector. Just as an indication of it being sort of early, earlier in its, in its demonstration of where we are in the cycle. 

But outside recruiters, I'd also point to the construction market. So new house building volumes are down substantially. And this has been the case since the mini budget last year. But as Ben mentioned, more recently, a pick up an interest rate has been followed through by an increase in mortgage rates. So we're seeing this week, some providers increasing their mortgage rates by about 70 basis points. And so that does not bode well for the sector and it certainly indicates that this summer is going to be tough for the housing sector, and it's not getting better which, which I think many had hoped it would be by this point. 

And so together these play into a view that there is weakness in the UK market, it's not just the UK, there are global markets as well struggling. And it supports what our cautious view is and our cautious outlook, which we've had for some time now, of our economists do have a base case of recession. The question of the timing of that, it certainly feels that it's been pushed out in the US, but that certainly is the base case. 

But what it does do is, it means that when we're thinking about the portfolio, we are considering the balance within the portfolio. So whilst we're not really taking macro bets, that's not particularly our strength, we're looking for stock specifics, when we're identifying companies for the portfolio, on a relative basis, we do feel that facing an uncertain and cautious outlook, it is sensible to have a balanced portfolio of quality companies, which offer an attractive total return. So both the quality and the income emphasis of DIGIT should position the portfolio relatively well within the market during some tough times. So now, as a reminder, we're looking for companies that have got strong balance sheets, which have got strong competitive positioning, exposed to structural markets strong financials and are in a good place to deliver both income but also capital return. So we think, you know, there are there are sort of causes to be concerned. And that needs to be considered when you're constructing the portfolio.

But maybe I could talk a bit about some of the new holdings that we've introduced to the portfolio with that in mind. So we've introduced Soft Cat, which is a UK-based value-added reseller of IT products, hardware and software. And so the company is now the leading reseller of IT in the UK. And we see it as an ESG leader, the company has got a really strong position abroad offering a strong culture. And this feeds into its customer relationships, which means the company has demonstrated a really strong track record of growing its wallet share with its customers, their customers are spending more of their IT spend with Soft Cat. So there's the sort of long term question of, of IT spending. And that's probably a pocket of, of positive strength that you're seeing in the market, which was maybe better than people expected this year, going into the year. And you've got that, but then you've also got their competitive positioning and their ability to take market share. So that's a relatively new holding in the portfolio. 

And we've also introduced Mercedes, and the company there, you know, it is a cyclical industry. So sort of not going to deny that. But the company has done a lot of work in terms of its positioning, and we think that it's benefiting from premiuimisation trend. From an ESG perspective, we see it as an improver. So the key question, there will be how the company positions its products for a transition towards electric vehicles and hybrids. But we think the valuation is attractive, certainly, it's trading to a material discount to peers of Porsche and Ferrari. And, and it demonstrates a strong shareholder distribution, and a yield of over 7%. So those are two names that we've added to the portfolio, which really based on our stock specific conviction in the names. 

Cherry: Great. Okay. Thanks, Rebecca. Ben, back to you. Since we last spoke, DIGITs released its annual results. Anything you'd highlight from that? 

Ben: Well, we should probably say yes, shouldn't be really given, you know, we spent hours writing the reports and all the rest of it for it.

What to pick out there. I think there's, there's a couple of things looking back and a couple of things, a couple of things looking forward. So I think overall last year, not a vintage year for performance in relative sense, we underperformed by a bit against the market, but I think we feel that was probably a par score, given our style and given the sustainable focus of the strategy.

But we would point to, you know, continued increase in the dividend, you know, up 1.7% and a balance sheet that remains strong so gearing, you know, 7%- 8%, 70% of one year's dividend in reserve. A number of companies which we own in the portfolio, don't pay yield. So we would say, you know, a portfolio that certainly has a lot of flexibility isn't being squeezed the nines to deliver income, and it also retains strong potential for long term total return, as Rebecca was saying earlier, so we feel in pretty good shape. 

And I think as we've moved into a sort of environment that may not have necessarily tailwinds for our approach, but where we think some of those headwinds have perhaps been mitigated a little bit, you know, I think we're feeling pretty good about the prospects for the portfolio over the, over the medium term. And I think that's being driven by the fact that we think sustainability is going to come back onto people's agenda. So that I think will be helpful for our overall approach. And I think in general, that focus on you know, high quality companies that could generate structural growth as opposed to relying on the cycle, we think in an environment that seems somewhat late cycle and where growth is coming harder to come by, you know, should favour those types of businesses. And I think we feel, in absolute sense, somewhat cautious, but in a relative sense, relatively optimistic. And I think, you know, if you do get the opportunity to have a read through the annual report, and hopefully it's a helpful document in terms of setting out, you know, more of the details on how we and how we see things evolving, how we, how we do things on a day to day basis. And as I say, you know, I think we both feel sort of relatively optimistic looking forward. 

Cherry: Okay, great. Thanks. And then, Rebecca, on that sort of cyclicality point there. I was hoping we could talk about some of the energy providers in the portfolio, there's been quite a drop in energy prices. But I'm wondering whether the energy companies with a strong kind of renewables footprint have fared a little better. Could you talk me through that? 

Rebecca: Yeah, so we have exposure to the sector. So SSE is one of our top holdings. And as a background, as you mentioned, you know, there has been volatility within the energy market. So as a reminder, energy prices spiked, following the invasion of Ukraine and Russia cutting off gas supplies to Europe. And given the connection between power prices, they sort of move in tandem with gas prices. They have come down and this year, due to it being a milder winter, there's been lower demand due to those higher prices. So sort of that feeding through and also the gas storage, availability has been healthier than people had thought towards the end of last year. 

But gas prices and energy prices do remain above historic levels. So, for a company like SSE, they should benefit from a underlying revenue perspective, from higher energy prices, an element of their network business, their revenues are inflation linked, that does provide that inflation hedge and the renewables business as well. The profitability will be driven by energy prices. So whilst they've come down, they do remain above historic levels. And actually above, the forward curve is above where people's expectations are in the forecast. 

On a near term basis, I think, you know, an element of maybe the disconnect between the share price and energy prices probably comes down to the level of hedging which these companies put in place. So they're pretty well hedged this year by 85%. And then and then two thirds hedge for next year. So that offsets it to an extent, but over the longer term, if energy prices stay where they are at these elevated levels, and that will certainly be supportive for the earnings of the business.

But I think the key driver for SSE and you know, one of the main reasons for its holding is not we're not really using it for just to pay power prices. We really believe in the long term investment that requirements in the UK in order to transition the grid towards low carbon energy. And SSE has got a very important part to play within that, there's a huge amount of investment required in electricity transmission to support a change in energy mix, so SSE itself is going to see this asset base grow. It's investing in both its network's business about an eight and a half billion up to 2027 and 7 billion in the renewables business, which should see it renewables earnings double out to 2027. So the company's gone from really changed, its shape. And when we look at the outlook for the business, it is looking to deliver some really strong underlying growth and it's in operating performance. And then from an income perspective, we see that following the dividend rebasing, it can afford its dividend and it has guided to healthy 5 to 10% dividend growth over the medium term. So it also provides that earnings and total return, dividend, total return sort of attractive characteristics to which we're looking for within the portfolio.

Cherry: Great. Okay, we'll wrap up there. So thank you, Rebecca and Ben 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 tuning in. Until next time.