Fund
Manager's Report
Market review
The UK equity market produced
positive returns during the year, with the FTSE All-Share Index up
by 7.9% on a total return basis. Falling inflation and a pause in
interest rate hikes by central banks, especially the US, UK and
Europe, were the main driving forces for equity returns in 2023.
Inflation in the UK (as measured by CPI), which started the year at
9.2%, fell to 4.2% by December, benefitting from lower energy
prices, the loosening of supply chains and fading food price
inflation. The Bank of England increased interest rates five times
in the year to reach 5.25% by August, before pausing.
The UK economy weakened during the year and
slipped into a technical recession in the fourth quarter, albeit
GDP growth was only modestly negative.
The UK market performance was fairly
broad based with the mid-cap FTSE 250 (+8.0%) marginally
outperforming the larger-cap FTSE 100 (+7.9%). However, the vast
majority of performance from medium sized companies came in the
fourth quarter as markets reacted positively to inflation falling
more than expected in October. Despite the recent rebound in that
area of the market, it has still significantly underperformed mega
cap companies (the largest 20 companies in the UK) over the past
two years. Cyclical sectors performed best over the year with
financials, industrials and consumer discretionary outperforming,
while defensive sectors such as health care, consumer staples and
telecommunications lagged. Despite the fall in the oil price during
the year, due to concerns over Chinese demand given its weakening
economy, the oil & gas sector outperformed. The mining sector
underperformed in contrast, despite iron ore and copper prices
rising, as production issues and cost inflation weighed on sector
profits.
Bonds were volatile during the year
with yields initially rising in the first half of the year to
reflect stubbornly high inflation and increased interest rates. The
UK 10-year gilt yield rose from 3.7% at the start of the year to
reach a peak of 4.7% in August. Despite the hawkish narrative from
central bankers globally, bond yields fell dramatically in the
fourth quarter as the market started to price in rate cuts in early
2024 given that inflation began to decline below expectations,
particularly in North America. The 10-year gilt yield finished the
year at 3.5%, albeit it has since risen as markets have had to
reassess their estimates of when the first rate cut may come. Both
government and corporate bonds produced positive returns for the
year after negative returns in the previous two years.
Performance review
The Company's NAV (debt at fair
value) returned 9.8% on a total return basis, outperforming the
benchmark's gain of 8.1%. Good stock selection within the equity
portfolio drove the outperformance, while gearing also contributed
positively.
The equity portfolio gained 10.4% on
a total return basis during the year, outperforming the FTSE
All-Share Index return of 7.9%. The portfolio's holdings in
financials 3i and Intermediate Capital were positive for
performance. Private equity group 3i benefitted from its portfolio
holding in Action, the European discount retailer, which delivered
strong profit growth underpinned by its value proposition and its
store roll out strategy. Despite a more difficult macro
environment, alternative asset manager Intermediate Capital
continued to attract inflows with the company delivering its 4-year
fundraising target a year ahead of expectations.
The portfolio's positions in other
consumer stocks that offer value to customers also performed well.
B&M European Value Retail saw good growth in volumes
benefitting from more cost-conscious consumers given the "cost of
living" crisis. Tesco also outperformed with the company's drive to
become the cheapest full line grocer producing market share gains,
good profit growth and attractive cash flow. Elsewhere,
holdings in Hilton Food Group and RELX also aided performance.
Hilton Food Group reported resilient trading in its core meat
division, while management action to improve its troubled seafood
business showed progress with the business back in profit by the
end of the year. RELX announced strong organic growth ahead of its
historic average, benefitting from its continued investment in
technology tools and analytics.
On the negative side the portfolio's
holdings in British American Tobacco, Anglo American and NatWest
detracted from returns. British American Tobacco announced a payout
of $635 million to resolve investigations by the US Department of
Justice into the company's historical business activities in North
Korea. It also disappointed the market with weaker trading, the
suspension of the share buyback and a non-cash impairment charge of
£25 billion relating to the Reynolds acquisition in 2017. Anglo
American shares were impacted by falling PGM (Platinum Group
Metals) prices, while the announced reduction in production
guidance towards the end of the year also disappointed investors.
Despite higher interest rates, NatWest reported weaker margins
given increased competition in savings and mortgage
products.
The fixed income portfolio rose 4.6%
on a total return basis during the year, but this lagged the 8.6%
return from the ICE BofA Sterling Non-Gilts Index.
The portfolio's exposure to short duration
government bonds was detrimental to relative performance given the
underperformance of gilts relative to UK corporate bonds. The
weakness in the US dollar also created a headwind to relative
performance for the US bond holdings. Holdings in high yield bonds,
such as Direct Line, Bupa, CenterParcs and Virgin Media, were
positive for performance given the more resilient UK economy saw
credit spreads tighten during the year.
Income review
On a headline basis UK market
dividends fell 3.7% (according to the Computershare UK Dividend
Monitor), however, this was driven by a decline in special
dividends versus 2022, and the strength of sterling during the year
given the number of large companies that declare their dividends in
dollars. On an underlying dividend basis (ex special dividends),
aggregate UK market dividends grew 5.4% at constant currency. This
was primarily due to good growth in dividends from banks and oil
& gas companies.
The income return for the Company in
2023 marginally increased to 10.39p per share, from 10.37p in 2022.
Despite income from underlying dividends in the equity
portfolio growing 6.8% in the year, there were a number of
headwinds which offset this. Special dividends were significantly
down from the prior year with only £241,000 earned by the Company
versus £1.1 million in 2022. Given the rise in interest rates
during the period, the Company's interest costs charged to income
from its revolving credit facility also increased, although income
from the bond portfolio also rose given the higher yields available
which helped dampen this impact.
During the year the Board declared a
full year dividend of 10.35p which was fully covered by earnings
with £128,000 being added to revenue reserves. This was an increase
of 2.0% over the dividend in 2022 (10.15p) and represents the
eleventh consecutive year of dividend growth, maintaining the
Company's status as an AIC Next Generation Dividend Hero. The
dividend has grown at a compound annual growth rate of 2.0% over
those 11 years. Revenue reserves as at 31 December 2023 were £8.9
million.
Portfolio Activity
As at the end of the year gearing
was 21.4%, in line with the level as at the end of 2022. A net £4.4
million was added to the bond portfolio taking advantage of the
move higher in yields. New positions were initiated in both
investment grade and high yield bonds but in typically higher
quality, non-cyclical businesses such as Électricité de France (EDF) (European
utility), Allwyn Entertainment (European lottery operator) and
Banijay Entertainment (TV content creator). In the middle of the
year, some of the lowest yielding investment grade bonds in the
portfolio were sold, where credit spreads were particularly tight,
and reinvested in short dated government bonds, both a UK gilt and
a US treasury bond. The bond portfolio represented 12.3% and 14.9%
of gross and net assets respectively as at the end of
December.
New positions initiated in the
equity portfolio included DCC, Conduit Re and Engie. DCC is an
international sales, marketing and distribution company operating
in the LPG, oil, technology and health care sectors. It is a
resilient business with strong free cash flow, high returns and a
robust balance sheet which should support further accretive bolt on
acquisitions. Engie is a French integrated utility and is a
diversified business involved in the generation, distribution and
supply of energy in Europe and Latin America. The company has a
credible business plan with the build out of its renewable energy
project pipeline likely to lead to good earnings growth. Conduit Re
is a specialist property and casualty reinsurer with a diversified
portfolio of reinsurance risks. Given the capacity that has come
out of the reinsurance market after a number of years of large
losses, the market is entering a period of strong premium rate
rises which should underpin high returns over the medium term. The
valuation is attractive with the company trading at a discount to
its net asset value.
In the second half of the year we
started to position the equity portfolio for a cyclical recovery,
taking advantage of attractive valuations in more domestic and
cyclical businesses on the assumption that interest rates were near
peak levels for this cycle. New holdings were initiated in Genuit,
Taylor Wimpey and British Land.
Genuit is the UK's leading provider
of plastic piping systems for residential, commercial and
infrastructure sectors. The company is exposed to a number of
structural tailwinds enforced by government regulation while new
management are restructuring the business to drive cost
efficiencies and higher margins over the longer term. Although the
outlook for the UK housing market is uncertain, we believed this
was already discounted with Taylor Wimpey's share trading at a
discount to its book value. The company has a very strong balance
sheet and with mortgage rates starting to fall, transaction volumes
should start to recover. British Land is a diversified UK
commercial real estate company with exposure to London office
campuses and wider UK retail exposure. After a number of years of
falling prices, we believe that property values have now troughed,
especially in retail, while the company is also experiencing a
return of rental growth. The valuation is attractive with the
shares trading at a significant discount to its net asset
value.
During the year there was a general
trend to lower the Company's exposure to overseas stocks,
recognising the relative attractiveness of valuations in the UK
market. Holdings in McDonalds and Deutsche Post were sold after a
period of outperformance and where we believed the valuations had
reached a full level. Also the position in Scandinavian bank Nordea
was exited given the fears we had over the health of economies in
the region and its exposure to commercial real estate.
Elsewhere the holdings in Sage
Group, United Utilities and Vistry were also sold. Accounting
software company Sage Group had performed well, with the valuation
fully discounting a continuation of the company's strong organic
growth, which could come under pressure from a slowing
macro-economic environment. We believe the next regulatory review
period could be difficult for United Utilities given the
significant investment needed in waste water infrastructure at a
time when there is increased scrutiny on consumer bills, debt
levels and dividend payments by the sector, especially with a
general election likely this year, which could weigh on the share
price. The Company sold its holding in housebuilder Vistry after a
change in strategy and capital allocation policy. While we agreed
with the change in strategy to focus solely on its Partnership
division, which builds affordable housing on a contracted basis, we
disagreed with the company's decision to suspend the dividend in
favour of buying back shares.
Outlook
Over the past two years, global
market returns, both equity and bonds, have been shaped by
inflation and the sharp rise in interest rates. Now that inflation
is falling, the pressure on central banks to keep monetary policy
tight is easing which suggests rates could be cut over the next 12
months. While the impact of the significant rise in interest rates
on economic growth needs to be carefully watched, consumer
borrowings are historically low, corporate balance sheets are
robust and the banking sector is well capitalised. With wage growth
also likely to outstrip inflation this year, the outlook for the UK
economy could be better than current low expectations, albeit still
below trend.
Similar to the UK, global economic
growth is likely to be better this year than expectations a year
ago, given that the US economy has proved more resilient.
Offsetting this has been China, where economic growth has
disappointed despite the government introducing stimulus measures.
The US economy should avoid recession this year given manufacturing
lead indicators are now recovering and unemployment, albeit rising,
is still at low levels.
While a more subdued economic
environment, along with higher interest rates and higher costs, is
likely to be a headwind for earnings growth, equity valuations in
the UK are attractive both versus their own history and relative to
global equity markets and we have continued
to see overseas buyers make approaches to quoted UK
companies. Although one has to be mindful
of geopolitical risks, we remain cautiously optimistic that
equities can make positive progress over the medium term. As ever
the focus remains on finding good quality businesses at a
compelling valuation that can pay and grow an attractive
dividend.
David Smith
Fund
Manager
27
March 2024
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