The portfolio underperformed the FTSE All-Share Index (the 'Benchmark') during the six months ended 31 December 2022 leading to the NAV per Ordinary share rising by 4.0% compared to an increase in the Benchmark of 5.1% (both figures calculated on a total return basis).

From a style perspective the portfolio’s Quality bias continued to be a headwind to performance (albeit to a lesser extent than during the first half of the calendar year) as the Value factor outperformed. In sector terms, the portfolio’s underweight position in the Communication Services sector and overweight exposure to the Information Technology sector benefited performance. In contrast, the overweight positions in the Materials and Real Estate sectors detracted from relative performance. The holdings in Aveva, TotalEnergies and BHP were the most beneficial to relative returns while the holdings in Marshalls and Watkin Jones detracted the greatest, relatively. Not holding Vodafone and HSBC contributed positively to relative performance while not owning Glencore, Shell and Rio Tinto detracted from relative performance.

Three new holdings were purchased for the portfolio during the six months. The first purchase was the pharmaceutical company, Roche, which has a healthy balance sheet and a strong pipeline which we believe to be undervalued. The second new entrant was Games Workshop, the hobby miniatures company, which we see as a unique asset with strong quality credentials and an attractive dividend yield. The third purchase was LVMH, the European luxury goods company which offers strong long-term growth potential through its portfolio of well-known brands.

We increased exposure to a number of our existing holdings which we believe have high quality characteristics with attractive growth prospects at appealing valuations including Sage, Unilever, Kone, London Stock Exchange Group, Howden Joinery and Relx.

Ten holdings were sold during the period, of which three stocks were sold following takeover bids: Aveva, Euromoney and Countryside Partnerships (we continue to have a holding in the acquiror, Vistry). Concern around high levels of leverage and potential risk to dividends given rising discount rates and higher interest charges resulted in the sales of Sirius Real Estate, Assura and Unite Group in the real estate sector. The small holding in Watkin Jones was sold following a profit warning which led to a change in confidence in the company’s business model and concern about the risk of further downgrades. The residual position in Haleon, the consumer healthcare business which was spun-out from GSK, was exited. Finally, the small positions in Bodycote and Weir were sold given more attractive opportunities.

We reduced the exposure to a number of holdings where we have higher conviction in other names in their respective sectors including Ashmore and Nestlé. The holding in AstraZeneca was reduced in order to manage its increasingly large weight in the portfolio.

We continued our measured option-writing programme which is based on our fundamental analysis of holdings in the portfolio. We believe that the option-writing strategy, which we have now employed for over 10 years, is of benefit to the Company by diversifying and modestly increasing the level of income generated and providing headroom to invest in companies with lower starting yields but better dividend and capital growth prospects.

One of the tenets of our investment philosophy is the belief that over the long term in order to grow dividends a company needs to grow its earnings and that high quality companies are best placed to do that. We believe that the portfolio is very well positioned to do just this. Looking at the portfolio from a quantitative perspective at the end of the period, typical measures of portfolio quality such as returns measures and earnings stability were high in absolute terms and considerably better than the Benchmark (for example, in aggregate, the return on equity and return on assets of the portfolio holdings was 24.1% and 8.2% respectively, compared to the Benchmark at 17.0% and 5.7% respectively). Furthermore, the portfolio generates a dividend yield above the Benchmark. At 31 December 2022, the portfolio traded on a P/E multiple of 13.8x compared to the Benchmark on 11.8x: a little more expensive but to our minds a small price to pay for a considerably better quality portfolio and one still very attractively valued in absolute terms.

Environmental, Social and Governance (“ESG”)

ESG engagement issues are addressed as part of our regular meetings with management.  However, we also engage on a variety of specific issues outside our regular meetings cycle. It should be noted that given the quality threshold inherent in the portfolio, these meetings are rarely about issues for which we hold significant concerns. To provide a couple of examples of our engagement during the period;. firstly, we met with Nordea to discuss their targets for green lending and reducing financed carbon emissions in their lending portfolio. Nordea appear well placed to benefit from the rise in green bonds and are on a positive trajectory towards achieving their climate targets; and, secondly, we conducted a meeting with London Stock Exchange Group (“LSEG”) to discuss the company’s approach to human capital management in the context of the large acquisition of Refinitiv and a competitive market for technology talent. We think LSEG are managing these challenges well.

Market and Economic Background

The UK equity market rose by 5.1% on a total return basis over the six month period. The period was characterised by high levels of inflation, monetary policy tightening and concerns about a potential recession. Sentiment towards the outlook ebbed and flowed at times with strong corporate earnings providing some comfort and some optimism that central banks would slow the pace of rate hikes, contrasted with periods of growing fears about recession risks.

Performance at a sector level was mixed. Mining and oil and gas companies performed well but telecommunications, media and real estate companies struggled. The FTSE100 Index outperformed the more domestically focused FTSE250 Index over the period.

Domestic economic data was generally weak. UK GDP was unchanged in the fourth quarter of 2022 following a decline of 0.2% in the third quarter. The UK is the only Group of Seven (“G7”) country not to fully recover output lost during the Covid-19 pandemic with the economy 0.8% smaller than at the end of 2019. Consumer confidence was reported to be at its lowest level since records began in 1974. Conversely, employment data generally continued to be strong given the shortage of labour.

Inflation continued to be high with the Consumer Prices Index reaching 11.1% in October, the highest level in more than four decades. The government announced caps to household energy bills for the next two years. Widespread strike action towards the end of 2022 weighed on sectors including transport, health, education, and postal services. The Bank of England (“BoE”) acted to control inflation by raising interest rates multiple times over the period, with the policy rate ending the year at 3.5% (and subsequently has been increased to 4.0%).

Political uncertainty was elevated as Prime Minister Johnson announced his resignation. The impact of fiscal policy on markets was heightened when the new Chancellor Kwarteng’s mini-budget, announcing widespread tax cuts, sparked a wave of selling of UK gilts and a substantial weakening of the pound. The BoE launched emergency measures to stabilise markets, delaying a planned gilt sale and instead committing to buy more gilts. UK government bond prices rose and the pound recovered somewhat as first Chancellor Kwarteng and then Prime Minister Truss resigned and many of their previously announced tax cuts were reversed.

Circumstances overseas also had an impact on the UK equity market. Towards the end of the period, signs that China would move away from their zero-covid policy was taken positively for stocks with exposure to the Chinese economy, including miners. Energy prices continued to be elevated compared to historic averages due to the impact of the Russian invasion of Ukraine on energy markets, which led to the energy sector outperforming.

Outlook

We expect the multiple headwinds facing the global economy – rate hikes, elevated energy costs and the continued impact of Covid-19 – to lead to challenging conditions in 2023. Uncertainties remain around the potential depth and severity of an economic downturn. For the UK, we currently forecast GDP to decline by 1.3% in 2023. We expect the BoE to continue to act to control inflation. For 2023, the Manager’s economists expect one more 0.50% rate increase from the BoE, which would see rates reach 4.5% in the spring. Given the recessionary outlook they then foresee a sharp cutting cycle resulting in base rates ending 2023 at 2.5%.

Although the backdrop may be challenging, we are optimistic about the outlook for the holdings in the portfolio. The portfolio is jam-packed with high quality, predominantly global businesses capable of delivering appealing long-term earnings and dividend growth at a modest aggregate valuation. In more difficult times it is those companies which can demonstrate pricing power and resilience, benefit from their robust balance sheets and are led by experienced management teams that are able to emerge stronger - ultimately this will be recognised in their valuations. That these companies are predominantly listed in the UK, a market that remains attractive on a relative, absolute and cyclically-adjusted basis, is doubly appealing. Therefore, we feel very comfortable maintaining our focus on excellent quality highly profitable businesses capable of delivering sustainable earnings and dividend growth over the long term.

Charles Luke and Iain Pyle,
abrdn Investments Limited
Investment Manager
28 February 2023

Discrete performance (%)

Total return; NAV to NAV, net income reinvested, GBP. Share price total return is on a mid-to-mid basis. Dividend calculations are to reinvest as at the ex-dividend date. NAV returns based on NAVs with debt valued at fair value. Source: abrdn Investments Limited, Lipper and Morningstar.

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.

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