Dunedin Income Growth Investment Trust: Update from the manager

In this episode of the abrdn Investment Trusts podcast we are joined by Ben Ritchie, manager of Dunedin Income Growth Investment Trust. He responds to the chatter that the UK is cheap, earnings are strong, UK companies are sound, but sentiment is still really poor. 

Capital at risk. 

For more information: www.dunedinincomegrowth.co.uk 

Transcript

 Cherry Raynard: Hello, and welcome to today's podcast on the Dunedin Income Growth Investment Trust. I'm Cherry Reynard and with me today is Trust Manager, Ben Ritchie. So, welcome, Ben. Let's start if we can with an existential question. So, people keep saying the UK is cheap, earnings are strong, UK companies are sound, but sentiment is still really poor. I'm wondering what could turn the tide on that?

Ben Ritchie: It's a great question. And it's something which I think UK investors have been wrestling with, for some considerable period of time. The discount at which UK assets are trading, particularly to the US, is as substantial as it pretty much ever has been. But I do think that it's important to look on a stock-by-stock basis. I'm always a little bit wary of the overall market evaluations because there are different sectors, there are different weightings, and fundamentally, there are different companies. And I do think that when you look at the UK market in a more granular sense, the valuations of some of the assets are indeed cheap. But they're not necessarily cheaper than, say, their European counterparts, but they are cheaper than their US counterparts. And I think that reflects (a) more positive sentiment towards the US from global investors and particularly US investors, and secondly, generally, a more cautious view on the outlook for Europe and the UK as well at the same time, and you've kind of got that dynamic. But I think in terms of the tide, I mean, if you look at the returns, total returns from UK equities through '22 and '23, who've actually been, I think, some of the best available in the world. And that does tend to be the case that UK equities in '22, at a time when global equities were down quite sharply, actually performed in aggregate pretty well. And I think that was because they were coming from a relatively low valuation base and meant that they weren't subject to the derating that we saw across large parts of equities during the year. So, I think one of the benefits, I guess, of a lowly valuation is actually that that should drive higher implied returns and I think we have seen that to some degree. So, I don't spend a huge amount of time worrying about the rating that the UK market's on, I spend time looking at the individual ratings that the stocks are on. As an investor, you want those to be as low as they possibly can be when you invest in as high as possible, when you decide to sell. So, fundamentally, I didn't see low valuations as a problem. I mean, if anything, it's an opportunity. But it is one of those things where investors continue to fret about that relative rating, but I think from an opportunity perspective, I think it's still positive for people looking to put money to work.

Cherry: One bit of good news this month was on inflation. I mean, how are you feeling about that? Are you kind of reserving judgement to see a more prolonged downward trend, or are you encouraged by that?

Ben: Well, I think it's been taken positively by markets - we've seen bond yields fall a little bit, we've seen sentiment shift a little bit towards domestic UK assets, which has been helpful, and certainly we've got stock level, quite a bit of exposure to domestically focused companies. So, that's undoubtedly pretty helpful. But I think we just have to see how it evolves. Generally speaking, people have underestimated the strength of UK inflation, I suppose in many ways. They've underestimated the strength of inflation globally. So, let's just wait and see how it evolves. But it is something that could be a helpful tailwind for sentiment and potentially valuations, if we continue to see that trend coming through over the second half. But as I say, you know, the inflation is one of those things that people don't really understand and I wouldn't claim to be a great expert in it. And I think we just to some extent, see how it evolves. In my fairly simplistic way of thinking about it is that the UK, when I look across the world, it has an unfortunate combination of elements which has made it more vulnerable to higher inflation. It had a very tight labour market. It's had a reasonable degree of fiscal stimulus during COVID. It's also had a very loose monetary policy for a considerable period of time. It's also then had exposure to the energy crisis, which has been caused by Ukraine. And on top of that, then you probably also had some dislocations and complexities around Brexit. And when you put that combination together, it's meant that CPI and core inflation have ended up being quite a bit higher. Now, whether or not they stay at that elevated level, I think we'll just have to see. Certainly, the peak has been higher and it's been a little later to start to fall compared to other places in Europe. But if you do look at some of the leading indicators like PPI - which is going into the manufacture of goods and so forth - and if you look at what's happened to gas prices - which will eventually feed through both for consumers and businesses - then you know, these things have been moving in the right direction. So, let's see, I think as you suggested Cherry, it's an encouraging sign. Let's hope that it does move in the right direction. And if it does, then that's probably likely to be quite positive for that mid part of the market, particularly that which is exposed to the UK.

Cherry: Now, I mean, another problem for the UK market is a sort of perception that it's only about certain industries and certain sectors, and maybe doesn't have access to some of these structural growth themes like green energy, or digitization, or that sort of thing. I mean, my impression is that you can actually get access to all those themes in a UK portfolio. But I was wondering if you could talk a bit more about that.

Ben: Yeah, so I think I think it's, to some degree, a fair observation, I think when you look at the makeup of the UK market, it's not overly endowed with companies in the technology space or in the in the green environment space, per se. I think that's, that's not an unreasonable initial observation. But I think that then means that, you know, if you think that those areas are attractive, then you're just gonna have to work a little bit harder to get exposure to those things. One of the advantages that DIGIT has is that it is able to invest up to 25% of its capital overseas, which does give us quite a bit of flexibility to go find companies that do have more exposure to those areas. So, that's pretty helpful. And the other element, I think that DIGIT has going forward, is that we're very much sort of all cap, in terms of our approach. So, we can look across the whole market, which again, gives us more flexibility. And so, when we're thinking about those sorts of themes and access to them, we are able to find exposure to the sort of environmental shifts which we're seeing. Companies such as SSE - a very big generator of renewable energy, a big pipeline of future wind power that will come through as well, that should drive good growth over the longer term. Something like National Grid - again, in terms of the electrification of the economy, it's a big part of what it delivers, both in the UK and in the US. And when we look to things like in the technology space, you know, we are able to access companies from overseas such as ASML, which is the global leader in lithography and which effectively supplies and helps the manufacturer of microchips that ultimately power the global economy. But closer to home, you've also got companies such as Sage, which again, you know, I think, perhaps an underestimated company, but a business that has transitioned towards the cloud in terms of its provision of accounting software for SME businesses. And again, I think, you know, sort of a quiet developer in terms of its expansion into the technology space. But further down the market cap, we're also able to find companies, such as Softcat, which effectively is a provider of IT equipment, software and hardware for smaller companies across the UK. Again, that's a business which benefits indirectly from that digitisation dynamic. So, I think that combination of looking overseas and looking down at the market cap gives us the flexibility to be able to find good exposure to some of those big long-term themes that are out there in the market, which we think will, you know, power growth for the portfolio over the long term. 

Cherry: Can we sort of zero in on the portfolio now and just talk about any kind of recent changes you've made?

Ben: So, we've added to a couple of companies during the period. We've increased our positions in LSE. It's a stock which we very much like. Again, we're talking about those thematics, it's really become a data business. It's taken advantage of its financial market infrastructure to generate data, which it then sells to its own customers, and that has been a big shift for the business. Certainly, from when I started, it really made its money through trading activity on the exchange and listing fees, was quite a market sensitive business. And today, it really has very little of that in terms of its revenue drivers. So, we've increased our position there quite significantly, as well. We've also been buying more in recent months of a company called Sirius Real Estate, which owns small industrial units primarily in Germany but also now in the UK. Again, we think that's a business that's well positioned for structural growth - the area experiencing high levels of demand, relatively constrained supply, and I think also, perhaps importantly, not seeing some of the bond yield pressures in Germany that it has done in other markets. So again, quite an interesting opportunity to be adding to that as well. And we also initiated over the last couple of months in Softcat, the company that I mentioned earlier. Again, a business which we think is well positioned for the long term in terms of supplying software and hardware primarily into the SME market in the UK. I think that that ability to meet needs, design bespoke solutions for companies, that's only going to be a growing area over the longer term. It will be a little bit cyclical but we think the long-term demand there is also quite attractive - a very strong balance sheet and the potential to generate excess dividends back to investors also looks pretty good to us. So, you know, a number of additions to the portfolio, which we think fit those ideas of looking for good long term structural growth, and hopefully, also businesses that have the capacity to generate healthy levels of cash flow and pay it back to us. I mean, Softcat and LSE don't have high dividends but we would have confidence that we'll see very good levels of growth from those dividends. Sirius offering, actually, a combination of a decent yield around five, five and a half percent, but also growing that quite attractively, as well. So, those have been the things that we've been looking at over the recent times.

Cherry: Unilever had another strong set of results, just recently, and I know that's an important holding in the trust, and it seems to have shown really strong pricing power to date. I wonder if you think that pricing power can be sustained as the impact of higher interest rates comes through and sort of impacts on households?

Ben: I think pricing power is an interesting dynamic. So, I would say the pricing lever is something that companies have not particularly exercised up until the inflationary pressures that we started to see coming through from COVID and all the factors that you mentioned earlier. I mean, I think initially, Unilever did suffer some margin pressures. And I would say in the categories that it operates in, some of them are more difficult to get full pricing back as well. But overall, I think as time has gone on, they've been able to do a pretty good job in terms of maintaining margins and pricing has also helped to move the top line ahead. And we're probably through the worst, in terms of the inflationary input cost pressures that they're going to face. And so, I think the key thing from here is, you know, retention of pricing, may be a little bit of additional element, but it's also then being in a position to benefit from full input costs that can allow your margins to re-expand. And so, to some extent, the game from here probably won't be necessarily about putting up prices, but it will be about maintaining price levels. And I suspect that also means that they're going to have to work quite hard on their cost base as well, to make sure that they put themselves in that position to be able to do that. And I think, you know, the pricing thing will also be something that companies will consider more, having been through a period of exercising the price lever, in the future than they did in the past. I think it may become a little bit more of a weapon. And the other side to it, then I think is there will become I think more of a polarised element to it, where not all companies will necessarily be able to deliver on that. And I think when everybody is raising prices and inflation levels are very high, it's relatively straightforward for all companies to put prices up. But when that tailwind starts to fade, then I think it will become more sort of stock specific as to who actually genuinely does have the capacity to nudge their prices ahead every year. And it might be that there are spaces - perhaps at the more, I guess, higher price level, and perhaps the more unique and stronger brands - where pricing may become more part of the mix. And Unilever will have bits of their portfolio that fall into that, you know, it certainly won't be the whole thing. So, I think overall, I think they've done a decent job in terms of navigating what's been tough markets. We've got a new CEO coming in there so, it'll be interesting to see how that comes through. And I think the one area that's going to be really interesting, is going to be on their emerging market footprint because that clearly has always been a big differentiator for Unilever from some of its competitors. That's not necessarily always been a positive over the recent years. And so, access to the faster growing markets like India, Indonesia, their position across Latin America, those may perhaps be markets where we're actually going to continue to see some good volume growth in a world when that may look a little bit scarcer. So, it's always going to be interesting to see how Unilever do in that area. But we would say that's potentially an underappreciated angle for them and, as a result, it continues to be a big holding for us in the trust.

Cherry: Now, just finally, The Investment Association reported that flows are continuing to come out of UK equities. I'm just wondering if, on the closed-ended side, whether you've seen that sort of reflected in the discount and whether you've had to take steps to address that at all?

Ben: I think there's a couple of elements here. I think first of all, you're continuing to see allocation away from UK equities in the broader marketplace. And I think that's simply a reflection of the fact that the UK in global benchmarks is a relatively small percentage, and domestic investors, probably still significantly overweight, to UK equities. So, I think there is that sort of natural selling element that has come into play. I don't know whether that will change over time. We've seen some noises from government about encouraging pension schemes to take more risk, but I think that largely has been around private market assets as opposed to public market assets. So, let's see. I think the discounts for investment trusts, and we have seen a bit of a widening both of DIGIT's discount and I think in the wider sector, I think the element there is probably more to do with interest rates and alternative opportunities for investors than it is to do, per se, with the appetite for UK equities. I think when you can get 5% on cash, a four and a half percent dividend yield is less appealing than two years ago - where cash rates were zero, a four and a half percent dividend yield looks pretty appealing. And I think this is an important thing and we've been discussing this with the board, in terms of how do we position the trust strategically for the long term? Because actually, there's more competition, in terms of the provision of simply a dividend yield of 4-5%. And so, we're gonna have to work harder to offer our investors a more compelling offer than simply saying, well, we've got a big dividend yield, and it's a big premium to cash and a premium to the FTSE. So, there's going to need to be more angles and offer for DIGIT going forward to attract investors to our capital base. But that's something that we've been working on over the last couple of years. So, it's not something that's a new element. And that's driven decisions such as the adoption of the sustainability overlay, which again, is a unique thing for DIGIT - not only in the UK equity income space but pretty much across the entire UK closed-ended space, where there are very few companies that have firm sustainable commitments and exclusions - which again, you know, we think is helpful for DIGIT, in terms of standing out from the crowd. It's also driven our decision to expand our overseas exposure. So, we increased the capacity to do that from 20 to 25% this year. And we will continue to look at ways that, not only can differentiate DIGIT, but which can also enhance the overall return prospects for our investors, whether that's looking at how we distribute income back to investors, and looking at ways in which we can deliver superior investment performance. Because the one thing that the investment trust can do that cash can't, is grow. Our dividend distributions have the capacity to grow, they have grown or been maintained every year for the last 42 years. And that's something that you won't get from your cash in the bank. And so, that element of some inflation protection that you can get from owning real assets, which DIGIT does in the form of equities, is also quite important. And I think we're going to have to work harder on explaining the benefits that investors can get both from a growing dividend from DIGIT and the capital returns - the total returns - that investors can get from owning the stock. Because, at the end of the day, the dividend yield and comparing to cash is just one half of the story for DIGIT. We'd expect there to also be a healthy capital return element to the total return picture. Whereas, just simply owning cash or owning a bond to maturity, well, the return you get is the return on the labour at the start, but it ain't going to be any more than that. And that I think is an important point of difference which we need to work hard on if we're going to get that discount tightened, and perhaps get the Trust back to the premium that it was on not that long ago.

Cherry: Thank you so much, Ben for all those insights today. You can find out more about the trust at dunedinincomegrowth.co.uk. And thank you all so much for tuning in.