Market Review

The UK equity market was resilient during the period under review despite a range of headwinds including new Covid-19 outbreaks, the Russia-Ukraine war, supply chain issues, rising inflation and interest rate hikes.

The discovery of the Omicron variant in November 2021 caused global stock markets to fall, as investors feared the imposition of new restrictions which could hamper economic growth. These fears were allayed in December 2021 as it became clear that while this latest variant was easily transmissible, its virulence was low, reducing the risk of another lockdown. Attention turned to the Russian invasion of Ukraine in February 2022, causing global equity markets to drop sharply. This drove a surge in commodity prices, adding to existing inflationary pressures caused by the tightness of labour markets and the global supply-chain bottlenecks in the aftermath of Covid-19 lockdowns. The UK Consumer Price Inflation rate hit 7.0% in March 2022, the highest level since 1992. The Bank of England (“BoE”) responded by hiking its base rate three times during the period, from 0.15% to 0.75%.

The resilience of the UK equity market during the period stands in contrast to the weakness seen in other major stock markets, many of which posted heavy declines.  The FTSE 100 Index outperformed, in GBP terms, the Dow Jones in the US, the DAX Index in Germany, the Nikkei 225 in Japan and the Hang Seng Index in Hong Kong.  This is largely explained by the sector composition of the UK market, with heavy weightings in traditional large cap sectors, such as resources and banks, which tend to perform relatively well in an environment of rising inflation and interest rates. Sector composition also explains the significant divergence in performance between the FTSE 100 index, which generated a positive total return of +7.8%, and the more domestically-orientated FTSE 250 and Small Cap indices, which fell by -7.3% and -5.6% respectively on fears over the impact of rising inflation on consumer spending.

Portfolio Performance

During the period, the portfolio delivered a total return of 2.5% while the total return of the Company’s reference index, the FTSE All-Share Index (the “Index”) was 4.7%.  As we have previously noted, we use an index-agnostic approach, which means that we weight our holdings according to our conviction levels, rather than their index weightings. We see this approach as most beneficial to shareholders over time, allowing us to construct a differentiated portfolio that can deliver on our objectives throughout the investment cycle.

While the constituents of the FTSE 100 Index typically account for around 80% of the total value of the Index, it is a measure of our process that the portfolio’s exposure to the FTSE 100 Index is below 60%.  This highlights the flexibility of the portfolio in allowing us to invest where we consider the best opportunities to be whilst not being committed to the Index weightings. 

Portfolio performance was impacted during the first three months of the financial year as many of our holdings were affected by nervousness about a new strain of the Covid-19 virus. Performance picked up as the period progressed, as many of our holdings recovered sharply.

Pulling together the key drivers of our performance relative to the Index:

1. We benefited from heavy exposure to Resources, both Basic Materials and Energy companies, which generated nearly 5% of relative performance. At the stock level, the largest contributors were BHP, Thungela Resources, Rio Tinto and Glencore. Resource companies had been amongst our largest purchases during the last financial year as we anticipated the potential benefit to the revenue account of their growing dividends, backed by surging cash flows. This is an example of a sector where income and capital growth go hand in hand.
2. Offsetting the benefit of our Resources holdings, we lost a similar amount of relative performance from our positioning in the Financials sector. Close Brothers gave up the gains it had made in the previous financial year as Winterflood volumes slowed sharply. Premier Miton and Ashmore fell back on signs of slowing fund flows. Among companies not held, the benefit of avoiding Prudential was more than offset by the impact from not owning HSBC during a period of rising interest rate expectations.
3. The portfolio lost just under 2% of relative performance in the Consumer Discretionary sector, as the positive impact of incoming bids for Vivo Energy and Playtech was offset by the under-performance of housebuilding stocks, Vistry and Bellway, on uncertainty over liabilities faced for cladding remediation, and Entain and 888 on slowing growth in online gaming revenues.
4. The gearing position, averaging 12.9% over the six month period, contributed just over 0.5% of relative performance.

Revenue Account

Dividends distributed by our portfolio holdings in the period under review rose by 11.8% to £4.7 million, compared to the £4.2 million received in the same six month period last year. This compares favourably to the Index where dividends grew by 2.2% over the same timeframe. The contribution from special dividends was extremely low at less than 1.0% of the dividend income (2021: 4.7%), reflecting the ongoing reduction in the number of special dividends being paid in the wake of the pandemic.

Net revenue was £4.2 million, or 12.3% higher than for the same period last year. Management fees were 7.3% higher, but this is a function of the increase in the value of the portfolio. Total expenditure by the portfolio, including all fees and charges, interest and tax was 7.6% higher than compared with the same period a year ago.

We are forecasting that the portfolio is currently delivering a gross dividend yield, before costs, of 5.7% based on the income expected to be generated by the portfolio over the financial year divided by the average portfolio value, representing a significant premium to the effective monthly average dividend yield of the Index of 3.1% for the same six month period.

The results for the period reflect our actions in meeting the first of the Board’s priorities, as set out in the Chairman’s Statement, in respect of income generation to cover the dividend for the financial year from the portfolio’s revenue earnings for that year.  The first six months of the financial year have seen continued progress in growing portfolio income, increasing our confidence in our ability to cover the dividend fully with earnings for the year ending 30 September 2022 and thereby paving the way for an acceleration in our dividend per share.  This is made possible by the abundance of higher yielding opportunities available following a prolonged period of macro dislocation. Sectors that stand out as delivering higher than expected dividends include Mining and Oil & Gas, both of which saw cash flows surge due to higher commodity prices and disciplined capital management.

For the wider UK equity market, the outlook for dividends has improved significantly since the pandemic, with dividend cover recovering to 2.0x in 2021. There are variations in the dividend outlook, stock by stock and sector by sector, which we will continue to navigate, but overall we are increasingly confident in our ability to achieve our income objectives.

Activity

Purchases

We remain mindful of the need to position the portfolio in stocks that can thrive in an inflationary environment. The tightening conditions that were already driving inflation higher in 2021 have intensified since the beginning of the Russia-Ukraine war as sanctions begin to bite. While there will be some impact on economic growth as demand is curbed by rising living costs, we remain confident in our ability to identify businesses that will deliver operational gearing, as revenues grow faster than costs. Our focus on cash flows is helping us to grow the revenue account and, in so doing, protect our shareholders against inflation.

Our primary focus is to look for companies undergoing positive change, supporting dividend growth that will drive a rapid return towards full dividend coverage. Over time, the companies that surprise positively on cash flows and dividends are the ones that tend to be rewarded with rising share prices.

Our largest purchases can be grouped into the following categories:

1. We increased our exposure to the Energy sector, starting a new holding in Harbour Energy and adding to BP, anticipating a surge in cash flows. The global oil market is very tight, as reflected in low inventory levels, following a period of depressed capital expenditure. This sets the scene for a benign period for shareholders as dividend growth resumes.
2. We also increased our weighting in Banks by starting a new holding in NatWest and adding to our holding in Standard Chartered, both of which are beneficiaries of rising base rates, putting upwards pressure on net interest income due to the stickiness of deposit pricing. In both cases, we expect credit quality to remain benign and costs to remain controlled. Improving momentum should drive a narrowing of the discount to NAV.
3. We selectively bought new holdings in small and mid-cap companies where we believe that positive change is being overlooked by the wider stock market. One example is retailer Halfords which is successfully implementing a strategy of increasing exposure to motoring services, acquiring the National Autocentres business, which will further increase the proportion of their revenues that are recurring. Another example is insurer Hiscox whose investment in brand and digital technology is set to drive rapid growth in their retail insurance business, particularly in the US.

Sales

Our largest sales can be grouped into the following categories:

1. This was another busy period for M&A in the portfolio. We sold our holding in Vivo Energy, sold the last of our Zegona Communications and reduced our holding in Playtech. In the Investment Manager’s review for the year ended 30 September 2021, I highlighted sales of four other holdings that had received bids. Since the year end two other holdings, River & Mercantile and Randall & Quilter, have entered bid situations. We continue to believe this is a sign of the deep intrinsic value inherent in this portfolio.
2. We took sizeable 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).
3. We reduced some Financials holdings where we felt waning conviction in the investment thesis beyond the attractiveness of the dividend – these included insurance stocks Sabre Insurance and Direct Line where regulatory change has dampened the prospect of an improvement in motor insuring pricing, and Polar Capital where fund flows are at risk from the concentration of assets under management in growth areas.

Outlook

Geopolitical risk has resulted in a number of cross-currents. Inflation expectations have continued to increase as a result of supply-chain bottlenecks and tight labour markets, driving bond yields higher. This has catalysed a market rotation towards value stocks, albeit the impact on our portfolio has been mixed as the value rally has been concentrated in large-cap value sectors with inflation hedge characteristics, at the exclusion of mid and small-cap holdings. This reflects an undertone of nervousness as the rising cost of living drives fears of stagflation. While the weakness of many small and mid-cap stocks was a headwind for the portfolio in the first six months of the financial year, we have historically found that these periods can create valuation opportunities as well managed businesses with solid fundamentals are sold off for spurious reasons. These opportunities can play out in the long sweeps of more stable market conditions in the wake of geopolitical disruption.

We will continue to use our influence to engage actively with management teams in driving positive outcomes on ESG issues. Our experience is that this is not only the right thing to do, but it can also help deliver improved financial returns. Our investment process is centred around the potential for change and it is therefore a natural part of our stock-level analysis to assess the change that companies are capable of achieving. We have recently observed that some of the most attractive valuations and highest dividend yields are available in stocks that other investors might exclude without considering this potential for change. This underlines the benefits of our flexibility, investing across different sectors across the UK market.

Looking ahead, we remain focused on growing portfolio income, as we believe that this creates a clear framework to deliver for shareholders, both in terms of income and capital. From an income perspective, the ongoing improvement in our revenue account makes us increasingly confident in our ability to cover the dividend with earnings for the year ending 30 September 2022 in line with the Board’s priorities.  Our confidence in the dividend outlook is in lockstep with our investment process which favours companies that are experiencing upgrades to their earnings and dividend forecasts, especially when this improvement is not priced into valuations. Resources is an example of a sector that offers both positive revisions and low valuations, helping us to achieve our income objectives.

From a capital perspective, we expect the inflationary backdrop to increase the attractions of lowly-rated companies offering a growing stream of cash flows and dividends, as investors recognise the role that these holdings can play in protecting against rising living costs. After a long period of dominance, growth stocks have faded as bond yields rise. As I described in the activity section, a number of our holdings have received bids in the past year, reflecting the widespread mismatch between share prices and underlying corporate fundamentals.

Despite the geopolitical uncertainty, we believe that these market conditions have the potential to be supportive for the portfolio, as we continue to find plenty of holdings that can help us achieve our objectives. We therefore look forward to the rest of the financial year with confidence.

Thomas Moore
Portfolio Manager
18 May 2022

Discrete performance (%)

Source: abrdn, total returns. The percentage growth figures are calculated over periods on a mid to mid basis. Past performance is not a guide to future results.

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.
• 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.
• 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.
• 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.
• The Company may charge expenses to capital which may erode the capital value of the investment.
• The Alternative Investment Market (AIM) is a flexible, international market that offers small and growing companies the benefits of trading on a world-class public market within a regulatory environment designed specifically for them. AIM is owned and operated by the London Stock Exchange. Companies that trade on AIM may be harder to buy and sell than larger companies and their share prices may move up and down very sharply because they have lower trading volumes and also because of the nature of the companies themselves. In times of economic difficulty, companies listed on AIM could fail altogether and you could lose all your money.
• The Company invests in the securities of smaller companies which are likely to carry a higher degree of risk than larger companies.

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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