Introduction

I am pleased to present the Half Yearly Report for the period ended 30 September 2023. I would like to welcome those new shareholders who have rolled over their shareholdings from abrdn Smaller Companies Income Trust PLC (“aSCIT”), following the completion of the combination of our two companies on 1 December 2023. The transaction offers significant benefits for both sets of shareholders, which I will describe in more detail later in this statement and in the subsequent events note on page 26. It has been an eventful period for the Company and I’m pleased to be able to end it on this positive note.

Investment objective

The Company’s investment objective is to provide shareholders with a high level of income, together with the potential for growth of both income and capital from a diversified portfolio substantially invested in UK equities but also in preference shares, convertibles and other fixed income securities.

Market Background

The main macro-economic trend in the six-month period was the continued rise in interest rates as central banks attempted to tackle inflation. The US Federal Reserve increased rates from 4.75% in March to 5.5% at the end of September and the Bank of England increased interest rates from 4.0% to 5.25%. In both cases rising short rates together with the corresponding rises in longer-term bond yields, have seen a rapid tightening of financial conditions since the end of 2021. Markets have accepted the likelihood that interest rates will remain higher for longer, and that the previous period of ultra-low interest rates will not be returned to. It is, however, increasingly likely that we are close to the peak in interest rates. Inflation has started to decline as key input costs such as energy and agricultural commodities fall, and although more persistent inputs such as wage inflation remain high, recent data suggests that economic growth is slowing, giving central banks some room to consider interest rate cuts as we move into 2024. Over the last twelve months the UK economy has defied the pessimists with economic growth being far more resilient than feared and more recent data has also indicated that the recovery post Covid has been at least as strong as elsewhere in the world. In the US, the economy has performed reasonably well, driven by robust consumer and business balance sheets and, alongside moderating inflation, this has increased the probability of a soft landing.

By contrast, the Chinese and European economies are facing some headwinds. The Chinese property market is heavily indebted and in considerable excess supply, with developer and homebuyer confidence very low. However, policy is now easing, which should prevent further downside outcomes and deflation becoming embedded in the economy, and this could even surprise markets on the upside. But in the Eurozone and the UK, the pass-through of earlier monetary policy tightening reflected in both short and longer-term interest rates, is still likely to mean that economic growth remains subdued in 2024 given the effects on mortgage rates and corporate borrowing costs. Despite these forces, equity markets have been resilient, with the MSCI World Index up 3% over the six-month period, although it was up by as much as 10% at its high at the end of July. The UK FTSE All-Share Index benchmark did not quite keep pace, rising by 1.4% over the period in total return terms. Performance by sector was mixed. Technology was the best performing sector in the UK, rising by 14.5%, but remains a small weight in the market. Energy (+11.5%) and Financials (+4.3%) performed well. Conversely, those sectors which are negatively correlated to rising bond yields, such as Consumer Staples (-5.0%) and Real Estate (-4.8%) lagged the market.

“Over the last twelve months the UK economy has defied the pessimists with economic growth being far more resilient than feared.”

Investment Performance Over the six-month period to 30 September 2023 the Company’s Net Asset Value (“NAV”) increased by 0.9% on a total return basis. This compares to the FTSE All-Share Index total return of 1.4% referred to above, and the average return from the open-ended UK Equity Income Sector of 0.5%. The main driver of performance was a recovery in the Company’s preference shares in the last few months as bond yields started to peak. The total return from the preference share portfolio during the period was 5.8%. Given the tough economic and equity market background we believe that this was a creditable performance from the Investment Manager. Disappointingly, the share price total return for the period was -3.1%, reflecting a widening of the discount at which the Ordinary shares trade relative to the NAV, from 3.1% at the start of the period to 7.0% at 30 September 2023. This is addressed in more detail below, under Discount and Share Buy Backs. The average discount over the 12 month period to 30 September 2023 was 3.1%, demonstrating that the discount widening has been a recent development. On an individual equity basis, the greatest positive contribution to performance came from the holding in Standard Chartered, where the shares rallied by 13% over the period as concerns around contagion from US banks at the start of the year receded and the company continued to report good performance. HSBC Holdings (+15%) benefitted from the same trends. There were also strong performances from a number of more cyclical UK companies, with Morgan Sindall (+26%), Direct Line Insurance (+26%), Melrose Industries (+15%) and Vistry Group (+21%) all performing well. Dechra Pharmaceuticals was a standout performer, with its shares rising by more than 30% following a bid from a private equity firm. A rally in energy stocks in September was also positive, with TotalEnergies and Shell both performing well.

The holding in aSCIT (+4%) also outperformed the benchmark, with the discount narrowing as a result of the proposal for the combination with the Company, as referred to above. Negative performers were more concentrated, with a number of portfolio holdings disappointing meaningfully. OSB (OneSavingsBank) fell by 30% after having to adjust assumptions made in its credit book in response to higher interest rates. The Investment Manager sees this as a one-off hit to the bank and considers the shares to be good value. Since the period end the shares have regained some lost ground after a reassuring update. Genus (-30%) was also weak as it faces headwinds from cyclical weakness in the Chinese pork market. Drax (-25%) has also been weak as the market has grown concerned about the viability of its BECCS biomass power generation project.

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. Past performance is not a guide to future results.

Portfolio Activity

Activity in the portfolio was, as ever, driven by the Investment Manager’s views on individual companies rather than a change in strategy. However, if we were to characterise the aim of trading during the period, it was to increase the resilience and strength of income from the portfolio. The Investment Manager’s view at the end of the 2023 financial year was that upwards progress from equity markets would be challenging in the short-term and that a period of some economic weakness was a reasonable possibility in the next 12-18 months. At the same time, rising interest rates and bond yields meant that cash and bonds were a reasonable alternative for investors looking for income. It is therefore important that the portfolio continues to provide a high level of income, and that this income generation will be resilient in any macro-economic downturn. In April, the Investment Manager made a number of trades to enhance income from the portfolio. It sold out of the position in Nordea. While it continues to like the company, it saw better value elsewhere in the sector and initiated a position in Dutch bank ING Group which it considers to be a low risk, well-funded and attractively priced bank. “If we were to characterise the aim of trading during the period, it was to increase the resilience and strength of income from the portfolio.” The Investment Manager also started a new position in Genus, which develops genetics for livestock. While the company is lower yielding than would usually be considered for the portfolio, it does pay a dividend and is very high quality, with a strong market position. The Investment Manager considers that the shares are valued attractively compared to their historic levels and that there are potential catalysts from gene editing development within the investment time horizon. Similar to the trades in European banks, the Investment Manager changed the UK bank exposure at the start of the period by switching from NatWest to Lloyds Banking Group.

This trade took advantage of the timing of dividend payments to enhance income and gives the Company exposure to a retail bank with a high level of sustainable returns and likely increasing distribution capacity as interest rates normalise and the group’s pension fund deficit is eliminated, reducing the drag on statutory profits. In May, the Investment Manager bought back into Sirius Real Estate. It exited this position late in 2022, with increasing concerns around commercial real estate. However, the shares were recently upgraded and the company has delivered strong cashflow and an increase in its dividend, signalling management’s confidence in cashflows to come. The Investment Manager therefore saw an opportunity to add back some weight in real estate to the portfolio, with the view that the sector could rally sharply once bond yields peak, provided demand remains resilient in the sector. The Investment Manager sold the Company’s holding in British American Tobacco, which had been a source of significant income in the portfolio for a long period of time. However, recent sales data had disappointed in its key US market and, after reducing the position over time, the Investment Manager decided to exit. The Company continues to hold a position in Imperial Brands, where the Investment Manager sees continued operational improvement after recent management change and a strategy focused on driving cash generation, which protects the dividend. In June, the Investment Manager exited the position in Dechra Pharmaceuticals. This was a recent purchase, in November last year. However, the company received a bid from a private equity buyer in April and the share price moved higher, giving an attractive 30%+ return in a short period of time. The proceeds from the sale were invested in a new holding, IP Group, which is an investor in early stage companies focused on three areas: Life Sciences, Clean Energy and Advanced Technology. More detail on this company is included in the Case Study on page 15.

The Investment Manager started one new position in July, buying Italian utility Enel. The holding provides exposure to long term investment growth in renewable power generation. More detail is provided in the Case Study on page 16. To fund the purchase and control the level of overseas exposure, the Investment Manager sold the remaining position in Bawag, which had done well since purchase but where the Investment Manager saw less attractive risk/reward. During August, the Investment Manager started a new position in Convatec, which produces medical supplies in areas such as wound care, infusion and stomas. To fund the purchase, the Investment Manager sold out of the holding in Smith & Nephew, where it saw less consistent delivery. Finally, the Investment Manager sold out of a small remaining position in Vodafone, where it saw the dividend as unlikely to grow and where the quality did not meet the level it looks for in portfolio companies.

Earnings and Dividends

The revenue earnings per share for the period were 7.66p, which compares to 7.50p for the equivalent period last year. Across the portfolio, there has been a modest increase in dividend income as companies continue to increase distributions from levels re-based during the Covid pandemic. Companies in certain sectors have seen tailwinds to earnings, with energy companies benefitting from higher commodity prices and banks from higher interest rates. One marked trend has been an increased preference for share buybacks amongst UK companies. This is understandable given the need to maintain flexibility with distributions and also the recognition that UK equities are lowly valued compared to history and other developed markets. The UK now has a higher buyback yield than the US, the long-time leader in this regard, providing an additional source of shareholder returns. Portfolio changes have also been made with the aim of enhancing the income generation. At a time of higher inflation and an uncertain economic outlook, the Investment Manager considers a high level of income as being important for the total return potential of the Company. ”The current annual rate of dividend Is 14.20p per Ordinary share, and represented a dividend yield of 6.1% based on the share price at the end of the period.“ A first interim dividend of 3.2p per Ordinary share in respect of the year ending 31 March 2024 was paid on 27 October 2023 (2023: first interim dividend – 3.2p).

The Board is declaring a second interim dividend of 3.2p per Ordinary share, payable on 31 January 2024 to shareholders on the register at close of business on 5 January 2024. Subject to unforeseen circumstances, it is proposed to pay a further interim dividend of 3.2p per Ordinary share prior to the Board deciding on the rate of final dividend at the time of reviewing the full year results. The current annual rate of dividend Is 14.20p per Ordinary share, and represented a dividend yield of 6.1% based on the share price at the end of the period. The Board considers that one of the key attractions of the Company is its high level of dividend and recognises that, in the current economic environment, there is likely to be a continuing demand for an attractive and reliable level of income. Whilst the Company remains on track to cover its annual dividend cost with net income, the Board is conscious of the Company’s accumulated revenue reserves which add security to the sustainability of the dividend.

Discount and Share Buy Backs

As stated above, the discount at which the price of the Company’s Ordinary shares trade relative to the NAV widened during the period, to 7.0% as at 30 September 2023. This is consistent with a general widening of discounts across the whole investment trust sector, but exacerbated by the transfer of the abrdn investment trust saving plans to Interactive Investor. Consequently, to help address the imbalance of supply and demand for the shares, and in accordance with the share buy-back authority provided by shareholders at the Annual General Meeting, the Company bought back 312,673 Ordinary shares during the period at a cost of £720,000 and an average discount of 9.2%, thereby providing an enhancement to the NAV for continuing shareholders. Since the period end, the Company has bought back a further 432,895 shares at a cost of £954,000. The Board will continue to make use of the share buy-back authority if it considers it in the interests of shareholders to do so. All shares bought back are held in treasury for future resale at a premium to the NAV.

Gearing

The Company has a £20 million loan facility of which £19 million was drawn down at the period end. Net of cash, this represented gearing of 23.1%, compared to 22.2% at the start of the period. The weighted average borrowing cost at the period end was 5.3% (31 March 2023 – 4.7%). The Board continually monitors the level of gearing and continues to take the view that the borrowings are notionally invested in the less volatile fixed income part of the portfolio which generates a high level of income, giving the Investment Manager greater ability to invest in a range of equity stocks with various yields. The Board believes that this combination should enable the Company to achieve a high and potentially growing level of dividend, and also deliver some capital appreciation for shareholders.

Board Changes

At the AGM in July 2024, I shall be stepping down from the Board having served for nine years. Having conducted a full succession process involving the evaluation of external candidates, the Board has reached the decision that Robin Archibald, who is the current Chair of the Audit Committee and Senior Independent Director, should replace me as Chairman upon my retirement. Jane Pearce will become the new Chair of the Audit Committee, and Helen Sinclair will become the new Senior Independent Director. We have separately announced that Simon White, who was Head of Investment Trusts at BlackRock from 2011 until June 2022 will be joining the Board as an independent non-executive Director on 1 January 2024. With these changes, the Board remains confident that we have the appropriate collective skills and experience to take the Company forward. Combination of aSCIT and Shires: On 26 July 2023, the Company announced that it had agreed terms with the Board of aSCIT for a proposed combination of the assets of the Company with those of aSCIT. This was achieved by a scheme of reconstruction and winding up of aSCIT, where assets were transferred to the Company in exchange for the issue of new Ordinary shares to aSCIT shareholders. A cash exit was also available under the scheme. aSCIT and Shires shareholders approved the scheme on 20 November 2023 and the scheme completed on 1 December. Shires issued 11,268,494 new Ordinary shares to aSCIT shareholders, with the new Shares admitted to trading on 4 December 2023.

The terms of the scheme were such that Shires shareholders did not suffer any dilution in their interests from the costs of the scheme. The combination has increased the size of Shires by more than 35%, to net assets of £101 million at the point when aSCIT’s assets transferred. As a result, the Company will benefit from the reducing tiered management fee structure at higher levels of assets under management, reducing the Ongoing Charges Ratio (“OCR”), and there should be improved secondary liquidity in the Company’s shares, as well as greater scale to promote the Company from. The Company will continue with its existing investment objective and policy and management arrangements, but will have a direct exposure to UK smaller companies rather than obtaining its exposure through investing in aSCIT. The Company’s gearing ratio has fallen as a result of the combination, from 23.1% at 30 September 2023 to 13.5% at the time of writing, which includes £4.4 million of cash awaiting investment. aSCIT’s shares were trading at a 12-month average discount of 15.7% before the announcement of its strategic review on 13 February 2023. aSCIT shareholders who have received new Shires shares will benefit from a much lower OCR, a significant increase in dividend yield outlook and an improved rating for their shareholding. We believe it has been a successful transaction for all concerned.

Outlook

UK equities look good value, trading at a material discount to other developed markets which is not justified by the fundamentals of earnings and dividends. Economic growth has been similar to other large economies and while inflation has been higher this is now falling. The yield available on UK equities is ahead of other markets and delivers an attractive rate of return. The preference shares held in the portfolio also offer a high yield and the potential decline in bond yields should provide a tailwind to their valuation. However, the Investment Manager remains cautious on equities globally, as it believes on a mediumterm view that markets are pricing in an overly benign outlook for macro-economic outcomes and interest rates. By sector, the expected peaking of interest rates creates opportunities for income investors in the UK, although the Investment Manager continues to look for higher quality and more defensive areas of the market. Certain high yield sectors, such as Utilities and Real Estate, are negatively correlated with bond yields and can perform well. Utilities, in particular, offer defensive exposure to falling bond yields and longer-term structural growth due to higher investment requirements through a period of energy transition. Sectors which are more economically sensitive and consumer exposed, such as Consumer Discretionary, look less attractive.

“While market conditions may remain challenging in the shorter-term, the Board remains confident in the defensive nature of the portfolio, its ability to deliver long term capital growth and, most importantly, the resilience of income, supported by substantial revenue reserves.”

It is reassuring to see more government attention on potential solutions to some issues around UK market valuations, including liquidity and a lack of home-grown investors into equities. While these will likely take time to bear fruit, it highlights that there remain relatively cheap valuations ascribed to UK equities that should provide rewards to patient investors. The combination of the Company and abrdn Smaller Companies Income Trust will increase direct exposure to small and mid-cap names in the portfolio. Despite the issues currently facing smaller companies, the Investment Manager sees this as an attractive area for new opportunities, and continues to invest in companies that have sufficient quality and income characteristics, independent of their size.

Overall, while market conditions may remain challenging in the shorter-term, the Board remains confident in the defensive nature of the portfolio, its ability to deliver long term capital growth and, most importantly, the resilience of income, supported by substantial revenue reserves.

Important Information: 

Risk factors you should consider prior to investing:

Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London, EC2M 4AG, authorised and regulated by the Financial Conduct Authority in the UK.

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