The third quarter earnings season saw the stock market in an unforgiving mood, sending share prices sliding for relatively minor earnings misses or small reductions in forward guidance. However, we also found it willing to reward companies that showed themselves capable of navigating these challenging conditions. This new-found discernment is welcome news for stock pickers.

The weaker companies tended to be those exposed to the consumer. Retail spending has been at its weakest level since the pandemic, with rising living costs and poor weather deterring shoppers. However, in contrast, a number of domestic cyclical stocks performed well, suggesting the broader UK economy may be stabilising.

There is increasing confidence that inflation has peaked. While the Bank of England continues to push back on interest rate cuts, bond yields have fallen, suggesting markets believe lower interest rates could be imminent. In general, the UK market is characterised by low valuations and low expectations, so where companies have seen an improvement in outlook and earnings, it has produced some pleasant surprises.

Another encouraging sign has been the strength of dividends and buybacks. The dividend plus buyback yield of the UK market is now 6.5%, compared to 4.5% for Europe and 3.5% for US. Where companies have good balance sheets and are cash generative, they have decided to buy back shares at their current low levels. This should support share prices.

It's been an interesting period with opportunities to both make and lose money. It’s the kind of environment we like because it differentiates between individual companies, rewarding resilient, stronger businesses. those being the ones where we put our capital. It sets us up for a better period as we move into 2024.

Corporate evolution

The UK market does not have an abundance of the type of ‘hot’ growth stocks that characterise the US market. At an index level, there is only a modest weighting in technology and likewise in proxy sectors. However, as an active manager, we can look beyond the index, invest across the market cap spectrum and determine our own view of an appropriate allocation. We also have the capacity to invest 25% outside the UK, which gives plenty of flexibility. By doing this, we can find companies exposed to exciting growth areas.

We also find a number of companies in transition. Sage, for example, has evolved significantly since its early years selling accounting software on CDs. Today, it is a digital, cloud-enabled business, operating across the globe. In doing so, it has created a faster-growing, more resilient business. RELX has seen a similar trajectory, starting as a traditional publisher of academic papers, but now providing digital analytical tools that have significantly enhanced its growth rate. 

Another example would be London Stock Exchange Group. This has moved away from the provision of market infrastructure, where it was paid for the transactions done on its platform, to an owner and seller of financial data. Today, 85% of sales are subscription-based, giving it greater visibility on earnings. It has put itself in a strong position, with the potential for long–term structural growth, including key strategic partnerships with Microsoft around the use of AI.

Engagement activity: housebuilders

The Future Home Standards is a UK Government initiative to make sure all new homes are ‘net zero ready’ from 2025. In mid-December, the Department for Levelling Up, Housing, and Communities published a consultation setting out its plans for the new rules. The consultation will run until 6 March 2024. The new rules are due to be introduced in Scotland in 2024, and England in 2025.

We have a position in Taylor Wimpey and need to ensure that it is ready for what comes next. The new rules are likely to require that any homes built will emit 75-80% less carbon than permitted under the current rules. Housebuilders need to ensure they can deliver those savings, and it will require preparation and innovation.

Taylor Wimpey has been trialing different technologies. It has created five homes built with different combinations to test energy provision, running costs and fabrication costs, including, for example, triple glazing or heat pumps. There will be significant divergence between the housebuilders in terms of how they meet these standards. In our view, those companies with better resources will be best placed to work on innovation and execution. We’ll continue to monitor the company’s progress and assess what it means for the economics and attractiveness of the new homes.

Unilever’s sustainability wobble

Unilever’s new chief executive, Hein Schumacher, has courted controversy, saying that the idea of ‘corporate purpose’ can be an unwelcome distraction for some of the group’s brands. While he has promised a strategy based on faster growth, greater productivity and a stronger “performance culture”, there have been concerns that he would rein in the company’s ambitious climate and social targets.

Unilever is one of our largest shareholdings, so it warrants investigation. There is no doubt that there is a lot of change taking place. Schumacher has been brought in to shake up the culture, focus on the company’s key brands and drive stronger growth in areas that have underperformed. In this, his intervention is needed and welcome.

Sustainability targets have been part of his root-and-branch review. He has reduced the number of targets the group has in place, arguing that they were too diffuse. The company had been missing short-term targets because there were too many. In principle, we are in favour of a more focused approach. We don’t need companies to disclose every metric and target, but instead to ensure they are focused on those factors most material to their business. We hope the new strategy will help us monitor short-term progress better and engage more effectively.

That said, there is more work to be done. The group needs to provide more clarity on its revised targets and we need to scrutinise those in detail. Unilever has a range of high quality brands, but there is an acknowledgment that it has under-delivered in recent years. We hope Schumacher can shake up its growth without collateral damage to its sustainability credentials. The two should not be incompatible.

Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future 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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