The International Monetary Fund (IMF) delivered a glum verdict on the UK economy in its most recent World Economic Outlook, suggesting that it would be the only G7 economy to shrink in 2023.
The assumption might be that the UK’s poorer economic performance will deter investors in the UK stock market. However we believe the reality is more nuanced. Sentiment towards the UK market has been weak for a long time and this latest verdict is unlikely to move the dial either way. If it continues to depress the value of UK equities, it may even allow us to invest in better companies at lower prices.
Equally, it is worth remembering that the UK stock market and the UK economy are not the same. More than two-thirds of revenues from FTSE All-Share companies come from outside the UK. Even among domestically focused businesses, it is possible to find companies driven by structural growth factors rather than the ebb and flow of economic growth. Not every company can escape the forces of the broader economy, but we’re looking for companies that do more than just match economic growth.
At Dunedin Income Growth Investment Trust (DIGIT), we find that the mood music has changed when we speak to corporate management teams. Most suggest that trading remains robust, and we have seen a number of reassuring updates, even in sectors such as housebuilding or retail. Input cost pressures are easing, particularly energy and freight costs. Labour markets remain tight, but there is some easing in sectors such as technology. There are undoubtedly problems for the UK economy, but the corporate sector is showing far stronger signs.
UK dividends in the year ahead
In its latest Dividend Monitor, Link showed dividends up 8% over 2022, buoyed by the weak pound, Covid recovery and a strong performance from mid-cap companies
This would be a reasonable result in a year where there are considerable challenges for the global economy. Our ambition is that we can generate stronger growth than that for the trust portfolio. We aim to do this by constructing a portfolio of quality companies with resilient and growing free cash flow, in addition to moderate option writing.
There have been some early dividend cuts. One which was notable for our portfolio was Direct Line, which cut its dividend to address a stretched balance sheet following underwriting and investment losses. When companies cut their dividends, we don’t have a hard and fast rule, but instead seek to understand why it’s happened. Sometimes that can be an opportunity to add more at an attractive price, sometimes it is a moment to sell. Often, we need to wait and see.
Nevertheless, we still have plenty of choice. In an environment where corporate earnings have been stronger than expected, many companies continue to grow their dividends.
The mid cap opportunity?
Last year was a tough year for mid caps versus large caps. Large caps were far better-represented among in-demand sectors such as oil and gas, mining or financials. The weakness in sterling drove returns for the large Dollar-earning companies, such as Diageo. In contrast, the mid cap sector was weighed down by its exposure to housebuilders and retail, both of which proved vulnerable to the cost-of-living crisis and higher interest rates.
However, this is not a persistent pattern. Over the long-term, UK mid and small caps have generally outpaced their large cap peers. In addition, the mid cap focused FTSE 250 Index has delivered attractive returns over the long term compared to global markets, outperforming the S&P 500 and MSCI World Index on total return basis since January 2000 (480%, 330% and 230% respectively). In reality, many of these companies have continued to trade well because they are exposed to idiosyncratic, structural growth trends. Whilst the last 12 months have been tough, valuations are looking attractive and we believe the long run track record of alpha generation from UK mid-caps will return.
It is our view that the most interesting companies still lie among the small and mid-cap companies, which is why the trust has a structural overweight position. Companies with a market cap of between £1bn and £10bn have tended to be in a sweet spot for growth and stability. It is where we see attractive long-term growth in profits, cashflows and dividends. Generally, when we were adding stocks in 2022, it was into smaller or mid-cap stocks, including Hiscox, Oxford Instruments or Sage.
Stock watch: Volvo & Coca-Cola Hellenic
DIGIT retains the ability to invest 20% of its market capitalisation in international companies. These tend to be specialist opportunities where we can’t find a UK equivalent and where international companies bring diversity to the portfolio. Volvo is a good example.
Volvo manufactures commercial trucks and construction equipment. It is a high quality company within a cyclical sector that should benefit from economic recovery when it appears. The company is making internal improvements such as boosting its services revenues, which should be supportive for margins and returns. It also has a strong balance sheet, is attractively valued, and has a high dividend yield relative to its peers.
Within the UK market, there are companies with high international revenues. Coca-Cola Hellenic is the anchor bottler for Coca-Cola in 29 countries across Europe and Africa. The company has high barriers to entry, plus attractive growth prospects given its exposure to faster-growing emerging markets where consumption per capita is below that of developed markets. Its valuation has been hit by its (small) exposure to Russia. It is taking significant steps to improve its ESG rating, aiming to reduce its plastic waste. We’re engaging with the management team to help them take action.
Companies selected for illustrative purposes only to demonstrate the investment management style described herein, and not as an investment recommendation or indication of performance.
Important information
Risk factors you should consider prior to investing:
- The value of investments, and the income from them, can go down as well as up and investors may get back less than the amount invested.
- Past performance is not a guide to future results.
- Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
- The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
- The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
- The Company may charge expenses to capital which may erode the capital value of the investment.
- Derivatives may be used, subject to restrictions set out for the Company, in order to manage risk and generate income. The market in derivatives can be volatile and there is a higher than average risk of loss.
- There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
- As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
- Certain trusts may seek to invest in higher yielding securities such as bonds, which are subject to credit risk, market price risk and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate.
- Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.
Other important information:
Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen’s Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.
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