After showing some resilience in the early months of the financial year, the UK equity market succumbed to a range of headwinds including geopolitical tensions, supply chain issues, rising inflation and interest rate hikes. By far the most significant event of the period was the Russian invasion of Ukraine in February 2022. This caused global equity markets to drop sharply and acted to depress sentiment, as investors worked through the second-round effects on economies and markets.
The most important economic impact of the war was a surge in oil and natural gas prices, adding to existing inflationary pressures. The resultant cost of living squeeze drove down consumer confidence, raising fears of a recession in the UK and Continental Europe. The UK Consumer Price Index inflation rate hit 10.1% in September 2022, the highest level since 1982. Central Banks around the world responded to rising prices by tightening monetary policy. Having held the base rate at 0.1% since March 2020, the Bank of England made its first interest rate increase in December 2021 and followed up with six further hikes by the end of the period, reaching 2.25% in September 2022. The base rate has increased to 3.0% at the time of writing.
Domestic political uncertainty remained a key driver of markets throughout the period, with Prime Minister Boris Johnson’s resignation in July followed by a prolonged leadership election process, culminating in the election of Liz Truss as his successor. Her tenure turned out to be short-lived, having spooked financial markets with a minibudget aimed at delivering on tax cutting pledges she made during her leadership campaign. The market reaction to this mini-budget was sufficiently fierce as to require the Bank of England to intervene, carrying out purchases of long-dated government bonds in order to restore orderly market conditions. This market dysfunction also led to reports that the Bank of England would delay the start of its planned sale of government bonds.
Despite such tumultuous conditions, the UK equity market was relatively resilient over the 12 months to 30 September 2022, with the Company’s reference Index, the FTSE All-Share Index, returning -4.0% over the period, performing less badly than other major indices globally. However, this masked significant variations in performance within the UK market. The FTSE 100 index produced a total return of 0.9%, with multi-national companies benefiting from the decline in sterling against the US dollar over the period. The more domesticallyorientated FTSE 250 and Small Cap indices fell sharply, producing a total return of -23.5% and -18.7% respectively. This divergence can be largely explained by significant variations at the sector level, with investors gravitating towards large cap sectors such as Oil and Gas and Banks on expectations that they would benefit from rising inflation and interest rates, at the same time as they shunned domestically-orientated sectors such as Housebuilders and Travel & Leisure on fears over the impact of rising inflation and interest rates on consumer spending.
The Company’s net asset value (“NAV”) total return was - 7.6% for the period. This was behind the total return of - 4.0% from the Company’s reference index, but was in line with the AIC sector's weighted average NAV total return.
The drivers of our performance over the period can be summarised as follows:
- The main detractors from performance were Financials, in particular small and mid cap holdings. Close Brothers on fears of slowing activity, Premier Miton on weaker fund flows and R&Q Insurance on the narrow rejection of a bid for the company. Among large cap financials, the contribution from owning Standard Chartered and avoiding Prudential was offset by not holding HSBC. Overall, this sector detracted just over 7% of relative performance.
- As noted in the Market Review, the sharp outperformance of large-cap stocks was a key feature of the stock market during the financial year. Overall, this was a drag on performance given the portfolio’s relatively heavy weightings in small and mid-cap stocks; itself a function of the index-agnostic approach that we use in constructing the portfolio. This approach involves sizing our positions according to our conviction levels, rather than anchoring around index weightings. While the constituents of the FTSE 100 Index typically account for around 80% of the total value of the Index, our portfolio’s exposure to the FTSE 100 Index is typically around 60% and was 51% at the end of the financial year. We are aware that this approach can cause variations in the portfolio’s return relative to its benchmark, particularly at times of heightened geopolitical nervousness when larger stocks tend to outperform. That said, we remain convinced that this approach can provide benefits over time, as it allows us to construct a differentiated portfolio with greater flexibility, enabling us to identify stocks that can help us to deliver on our objectives through the cycle and enables us to generate a diversified income stream.
- This was a busy period for M&A activity, with Go Ahead, ContourGlobal, River & Mercantile and Vivo Energy on the receiving end of bids all at meaningful share price premia. These four holdings generated just under 2% of relative performance.
- The next biggest detractor was Consumer Discretionary, notably housebuilder Vistry and sofa retailer DFS, as fears grew over the cost of living impact of Russia’s invasion of Ukraine, as well as Entain and 888 on slowing growth in online gaming revenues. This sector detracted just under 4% of relative performance.
- The gearing position, averaging 13.4% over the financial year, detracted around 0.7% of relative performance.
- The next biggest contributor to performance was Basic Resources, most notably Glencore and BHP, as commodity prices supported strong cash generation. This sector contributed just under 3% of relative performance. We significantly increased our weightings in these sectors last year in anticipation of the strong cash flows and dividends that these stocks are now delivering.
- On the positive side, the largest contributor to performance was the portfolio’s heavy weighting to Energy at a time of rising concerns over energy security. Notable outperformers were Thungela Resources, Diversified Energy and BP. This sector alone contributed over 7% of relative performance.
Spotlight on Thungela Resources
Thungela Resources spun out of Anglo American in June 2021. Rather than selling this tiny position of only 6,572 shares, we concluded that this highly cash-generative business was deeply under-valued, so we bought an additional 579,281 shares between June 2021 and January 2022 in order to make the holding more meaningful. We paid an average of 187 pence. The shares ended the financial year at 1,666 pence, nearly nine times higher than our initial purchase price. The stock also paid 393 pence of dividends per share during the financial year, taking the total return to 11 times our initial investment in only 15 months, making it one of the most profitable investment decisions we have made for this portfolio. Consensus estimates expect that the company will distribute over 600 pence per share (at the current exchange rate) in its next financial year indicating that the dividend received can be seen as recurring. We believe that this is a good example of the returns that our investment process can generate.
We have engaged with the management of Thungela to understand better the company’s approach to sustainability and then urge improvements where we see gaps. We have urged the company to set more ambitious goals, increase transparency and to commit to clearer timeframes for developing its sustainability roadmap, in particular on measures to reduce carbon emissions. We have provided Thungela with our recommendations on industry best practices as we seek to support the company’s growth in this area. We have been encouraged by Thungela’s development of an ESG framework, covering issues such as environmental stewardship and local community relations.
Dividends distributed by our portfolio in the period under review rose by 27.0% to £13.5 million, compared to the £10.6 million received last year. This compares favourably to the Index where dividends grew by 13% over the same timeframe. The contribution from special dividends remained low at 5.9% of the dividend income (2021: 5.7%), reflecting the continuing scarcity of special dividends in the wake of the pandemic.
Net revenue was £12.2 million, or 26.3% higher than last year. Management fees were 2.1% lower, but this is a function of the decrease in the value of the portfolio. Total expenditure before interest and tax was 9.0% higher than last year. This was largely due to the comparative year’s professional fees being a rebate as a result of reversal of provisions in the year prior.
We are forecasting that the portfolio is currently delivering a gross dividend yield, before costs, of 8.1% based on the income expected to be generated by the portfolio over the financial year divided by the portfolio value at the year end, representing a significant premium to the effective monthly average dividend yield of the Index of 3.8% as at 30 September 2022.
Recent interest rate hikes are unhelpful for our investment return as they increase the cost of our overdraft facility. However, the gap between the interest rate we pay for this overdraft facility and the dividend yield we earn on the portfolio, while narrower than it was a year ago, remains very wide by historical standards at around four percentage points at the time of writing.
This sharp recovery in the revenue account is a result of our focus on achieving the priorities set out by the Board at the time of the Covid-19 crisis. The Board emphasised that our first priority should be to build a portfolio that could deliver sufficient income to cover the dividend. I welcomed this challenge as I could see that it was consistent with our investment process which favours companies whose strong cash flow and dividend potential are not priced in by the market. During the financial year we identified many examples of stocks that fit this description, enabling our dividend cover to exceed 1x sooner than might have been expected in the midst of the Covid-19 crisis.
For the wider UK equity market, the outlook for dividends has improved significantly since the pandemic, with dividend cover recovering to 2.5x (on a 12 month forward basis), suggesting some cushion for corporates in the event that macro conditions deteriorate. We also have the advantage of selecting from a broad palette of UK stocks, with many different earnings drivers. This helps to underpin our confidence in the continued progression of our dividend per share in FY23.
The market backdrop has changed meaningfully in the past year, creating a new set of opportunities that we have attempted to seize upon. Inflation was already increasing prior to Russia’s invasion of Ukraine. Two key drivers of higher inflation were supply disruptions linked to the shutdown of the economy during Covid-19 and rampant growth in money supply caused by the Bank of England’s Quantitative Easing programme. The war in Ukraine only exacerbated existing inflationary trends, as natural gas and food supplies were disrupted. So it is against this backdrop that we have been carefully positioning the portfolio.
Our largest purchases are mostly companies whose cash flows have the potential to benefit from rising prices and interest rates, providing the portfolio with some inflation hedge characteristics:
- Oil & Gas: We increased our exposure to the Energy sector, adding to BP and starting a new holding in Harbour Energy, anticipating that tight upstream and downstream markets would persist, driving cash flows and dividends.
- Banks: We increased our weighting in Banks by starting a new holding in NatWest and adding to our holdings in Barclays and Standard Chartered, which we expect to be beneficiaries of rising base rates, as net interest income grows thanks to the stickiness of deposit pricing. Despite the sharp slowdown in economic growth, we expect bad debts to remain low, with significant impairment provisions already taken. If the banks navigate this downturn successfully, we should expect a substantial narrowing in the discount to NAV on which they trade.
- National Grid: We added to National Grid whose earnings are set to benefit from inflation-linked contracts in the UK, at the same time as their regulatory asset base starts to grow rapidly to deliver the infrastructure necessary for the transition to electric vehicles.
Our largest sales can be grouped into the following categories:
- Iron ore: We reduced our weightings in BHP and Rio Tinto in the sector half of the financial year, as we become more concerned about the outlook for the Chinese construction sector. After years of rapid growth in floor space, inventories are rising and activity levels are falling. This is important for BHP and Rio Tinto because the iron ore they sell is mainly used in the production of Chinese steel.
- Mergers & Acquisitions: This was a busy year for corporate activity in the portfolio. We sold our holdings in Go-Ahead, ContourGlobal and Vivo Energy after they received bids. We also received the proceeds from tender offers in River & Mercantile and Zegona Communications after they divested of their core divisions. We continue to see the high level of M&A activity as a sign of the intrinsic value in this portfolio.
- Online gaming: We took profits in Entain following the withdrawal of bid interest from DraftKings. While it was disappointing that the shares fell back following this announcement, we were still able to sell at over double the share price that we paid when we bought into the company in January 2017 (when it was called GVC Holdings). We also took profits in Playtech as the chances of a takeover approach diminished. The wider sector is seeing a slowdown in growth as regulation toughens and it becomes clearer that activity levels reached unsustainable levels during Covid-19 lockdowns.
OutlookIt is pleasing to report that the improvement in our portfolio income resulted in the dividend per share being amply covered by earnings per share in the 12 months to 30 September 2022. This has allowed the Board to resume meaingful dividend per share growth, while starting to rebuild our reserves after a hiatus of two years caused by the Covid-19 pandemic. It is a reflection of the benefits of the closed-end structure that we have come through such an exceptional period while maintaining our 22 year track record of consecutive dividend increases. It should be noted that this has been achieved without compromising the investment process, as market dislocation has created an abundance of stocks that fit our investment criteria. The result for shareholders is a high yield portfolio comprised of high conviction investment ideas.
The global economy is slowing as Central Banks try to control inflation leading to a high risk of recession in the UK and other major countries. This is a challenging backdrop, but we remain confident that we can navigate this environment successfully for the following reasons:
- Broad universe of stocks: As they are starting with high levels of dividend cover, we expect many UK stocks to deliver attractive dividend growth despite the uncertain economic situation. The UK equity market is highly diverse, allowing us to access a wide range of companies with different income drivers. Some companies will struggle in an inflationary environment, but others will thrive. Furthermore, the UK equity market provides exposure to different parts of the world. It seems likely that economic outturns will differ widely in the coming year. For example, the US will be far less affected by the Ukraine war than Germany, as a result of their radically different energy policies. In light of this, we can position our portfolio carefully through thoughtful analysis of how each company is likely to fare in the current environment.
- Tendency of share prices to price in recessions early: Recent research by Stifel has mapped the performance of the S&P 500 index to each US recession post-1945 and found that the stock market bottoms out 4 months before the end of the recession. While it is not possible to know in advance with any certainty when a recession will start or end, this is a reminder that recessions can provide opportunities to buy well-managed companies at attractive valuations.
- Style characteristics of the portfolio: We believe that the portfolio has a significant “margin of safety” as the relatively low valuations of our holdings do not appear to factor in their solid fundamentals. Our Matrix quant model indicates that the portfolio scores particularly highly on Valuation and Earnings Momentum factors, underlining our view that high yield need not come at the expense of high conviction. At the time of writing, the median PE (12 months forward) of our holdings is 8.9x. The median dividend cover (12 months forward) is 1.9x. We expect the valuations of our holdings to rerate, as investors respond to the strength of their corporate fundamentals.
- Inflation Protection: Stocks with inflation hedge characteristics; potentially benefiting from rising prices. We expect inflationary conditions to provide a tailwind to these companies, helping them to grow their cash flows and dividends. Examples include Shell, NatWest and National Grid. At the time of writing, this basket represented 37% of the portfolio. Objective: achieve real growth in income.
- Mispriced Yield: Stocks whose high yields indicate that the market is pricing in bad news. We believe these stocks are more resilient than their valuation implies. Examples include Legal & General, Diversified Energy and Chesnara. At the time of writing, this basket represented 24% of the portfolio. Objective: achieve above average income.
- Latent Growth: Stocks that are capable of delivering operational progress, driving growth on a mediumterm view once the current period of uncertainty abates. This change is being overlooked by the market. Examples include OneSavings Bank, Hiscox and DFS. At the time of writing, this basket represented 29% of the portfolio. Objective: achieve real growth in capital.
We expect each of these baskets to perform best in different scenarios. Inflation Protection stocks should perform best in an inflationary environment, driven by high commodity prices and rising interest rates. The Mispriced Yield basket should perform best in a rotation out of growth stocks into value stocks. Latent Growth stocks should perform best on any easing in inflationary pressures, perhaps triggered by a resolution to the Ukraine war. We would see the most adverse scenario for the portfolio as a prolonged and synchronised global recession, as this could drive down large swathes of the market. For now we see this as a low probability scenario given the variations in economic conditions around the world.
The UK is a particularly unloved stock market due to a series of political crises since the 2016 Brexit referendum. The scale of the UK’s furlough and energy bill support schemes have caused the UK’s debt/GDP ratio to approach 100%, although it should be noted that this is still the second lowest in the G7. The arrival of Rishi Sunak as the third Prime Minister in as many months heralds an era of more conventional economic policies. This has already calmed the markets, helping to drive a reduction in Gilt yields and a recovery in sterling. Amongst all the political ‘fear and loathing’, it is worth keeping in mind that the UK has many enduring strengths that make it a highly attractive destination for international capital. As has been demonstrated by all the recent M&A activity in our own portfolio, some international investors are coming to the view that UK companies are now attractively priced. It would not take much for broader attitudes to the UK to improve dramatically. This would be helpful for our portfolio given that we have a heavy position in UK domestic companies relative to the broader index and peer group.
Through turbulent times, we will remain focused on achieving our objective to provide shareholders with an above average income, while also providing real growth in capital and income. With inflation at its highest level in 40 years, the resonance of this investment objective is greater than usual and I will do my utmost to deliver on it for shareholders.