Market Review

UK equities staged a recovery over the 12 months to 30 September 2023 as investors responded positively to signs of stabilising politics, peaking inflation and the continued avoidance of economic recession.
The period began with a resolution to the political uncertainty that followed the resignation of Liz Truss in October 2022. The arrival of Rishi Sunak as Prime Minister allowed bond markets to stabilise on the expectation of responsible fiscal policy, thereby restoring investor confidence in the UK’s outlook.

With political turmoil fading from view, the market turned its attention towards inflation and its impact on monetary policy and economic growth. In the UK, consumer price inflation peaked at a 40-year high of 11.1% in October 2022, before falling back to 4.6% in October 2023. The Bank of England’s decision to hold rates at 5.25% in September, following 14 successive rate hikes since December 2021, raised hopes that monetary policy had tightened sufficiently to curb inflationary pressures. Tightness in the labour market is a particular focus for policymakers in gauging underlying inflationary pressure, with average weekly earnings growing at 8.1% in the year to August. The view Economists predicted that interest rates would remain elevated monetary policy is unlikely to loosen until wage growth decelerates was reflected in the Bank of England’s description of the likely profile of future interest rates as “Table Mountain”.

During the period, the transmission of higher rates to the global economy became clearer, with various fragilities becoming exposed. In March, Silicon Valley Bank and Credit Suisse both collapsed, prompting intervention from financial regulators to limit the contagion across the global financial system. In May, markets became rattled by the prospect of a US government debt default, further compounding the damage to bond markets, although Congress ultimately approved an eleventh-hour increase of the debt ceiling. In August, investors reacted badly to signs of growing stress in the Chinese housing market after years of excessive borrowing and overbuilding, with some large developers on the edge of default. In the UK, the impact of higher rates on housing activity and house prices was less acute, reflecting the reduction in household sector leverage since the 2008 financial crisis. Third quarter GDP data revealed that economic activity remains subdued, although recession continues to be avoided despite higher interest rates; a scenario that many economists would have dismissed as unlikely at the start of the year.

Although the FTSE All-Share Index returned 13.8% over the period, there were significant variations in performance within the UK market. The FTSE 100 index produced a total return of 14.7%, reflecting investors’ preference for larger, more liquid stocks during nervous market conditions. The more domestically-orientated FTSE 250 and Small Cap indices lagged, returning 10.0% and 7.5% respectively, as worries about higher interest rates caused investors to shun less liquid domestic cyclical stocks in favour of more defensive large caps. Over the two years to September 2023, a divergence of over 31% in total return has built up between the FTSE 100 and FTSE 250 indices, underlining the unusual magnitude of this move.

Revenue Account

Dividends distributed by our holdings in the period under review came in at £12.6 million, compared to the £13.5 million received last year, representing a reduction of 7.2%. This was largely caused by a sharp decline in the contribution from special dividends to £186,000 (from £800,000 in 2022). Excluding all special dividends from the calculation, to provide a clearer view of the underlying change in dividends, the reduction was 2.8%. The decline in special dividends reflects the tendency of management teams to favour share buybacks over special dividends, often because they deem their valuation to be unfairly cheap.

We note that 29 of our holdings – over half the portfolio – performed share buybacks during the financial year, underlining the intrinsic valuation attractions of the portfolio.

Net revenue was £11.1 million. Management fees were 9.9% lower and total expenditure before interest and tax was 7.7% lower than last year.

We are forecasting that the portfolio is currently delivering a gross dividend yield, before costs, of 7.6% based on the income expected to be generated by the portfolio over the financial year divided by the portfolio value at the year end, representing a significant premium to the dividend yield of the Index of 4.0% as at 30 September 2023.

During the financial year we focused on achieving the Board’s priority of delivering sufficient income to cover the dividend. We achieved this for a second year, although the market backdrop of a decelerating global economy, rising interest rates and geopolitical conflict made this a more challenging task than it was the previous financial year. The largest variation in portfolio income during the year was caused by the reduction in commodity prices, affecting some of our Energy and Mining holdings. The UK equity market has, in recent years, seen a concentration of dividends among a relatively small number of sectors due to a succession of macro shocks, specifically Covid-related dividend cuts, followed by Ukraine-related commodity price surge and economic slowdown linked to higher interest rates. Our portfolio was not immune from this increase in dividend concentration.

Having rebuilt dividend coverage since the Covid trough, we have turned our attention to taking portfolio action that will simultaneously enhance the portfolio’s income prospects and diversify the portfolio’s income generation across a broader range of stocks and sectors. We would expect this process to be assisted by a broadening in dividend payments across the UK market, especially once macro uncertainty eases sufficiently to encourage management teams to distribute surplus cash in the form of dividends.

Taking a step back, we are encouraged by the progress in our revenue account in the 2 years since the height of Covid. While share prices may continue to swing around on changing sentiment in relation to these macro drivers, we remain confident that the focus of our investment approach on delivery of cash flows and dividends remains the right one. For the wider UK equity market as a whole, dividend cover of 2.2x (on a 12 month forward basis) suggests some cushion should macro conditions remain tough. We continue to find many examples of stocks whose cash flow and dividend potential is not effectively priced in by the market. This provides us with the opportunity to buy well-managed businesses with sound dividend prospects at low valuations, helping to support our confidence in the continued progression of our dividend per share in the financial year to 30 September 2024.

Portfolio Performance

The Company’s net asset value (“NAV”) total return was 1.8% for the period. This return was lower than that of the Company’s Reference Index as the return of the index masked some sharp variations in performance within the UK equity market, reflecting an underlying nervousness that persisted throughout most of the period. In summary, our NAV lagged the index for two key reasons.

First, market conditions were not supportive for the Fund’s positioning. The outperformance of a narrow range of large-cap stocks, linked to the strong US dollar and ongoing investor de-allocations from domestic UK stocks, was a key feature of the stock market during the period. This dragged on performance given the portfolio’s heavy weighting in small- and mid-cap stocks, itself a function of the index-agnostic approach that we use in constructing the portfolio.Second, the portfolio suffered from some company-specific disappointments, mainly linked to the impact of falling commodity prices on some of our Energy holdings and the impact of higher interest rates on activity levels in some of our Financials and Consumer holdings.

Our portfolio’s exposure to the FTSE 100 Index was 52.6% at the end of the period, whereas the FTSE 100 Index represented 84.4% of the total value of the FTSE All-Share Index.

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.

Turning to specific stocks, the key drivers of our performance over the period are as follows: 

Activity

Purchases

During a period of rapidly changing expectations over the path for inflation and interest rates, we have applied our investment process to position the portfolio in stocks where we see the greatest potential to deliver income and capital growth. Our experience is that stock-level opportunities can become most abundant during times of volatile macro, as investors focus on economic data, rather than corporate fundamentals. Our largest purchase during the period was HSBC where we see rapid improvement in profitability thanks to the benefit of higher base rates, as well as the re-opening of the China/Hong Kong border. The business appears well prepared for a tough economic backdrop, with management running a high level of deposits and taking a cautious approach to lending. This sets the stock up to deliver attractive dividends, while also providing capital growth potential given the attractive returns being generated.

We added to our holding in National Grid which we see as well positioned to deliver the grid expansion necessary for the transition to electric vehicles. In the UK, National Grid benefits from inflation-linked contracts. The stock has fallen sharply due to its correlation with government bonds, providing us with an opportunity to add to our holding, with clear portfolio income benefits given the high yield. We bought a new holding in Ithaca Energy, whose huge cash generation is supporting extremely attractive dividends, with around one fifth of the company’s market cap being paid back to shareholders in the form of dividends in its first full year of listing.

We expect Ithaca’s heavy investment in the North Sea to provide it with significant up-front tax breaks, helping to mitigate the impact of the Energy Profits Levy. Among smaller cap stocks, we bought a new holding in Vanquis where we expect the new CEO to take rapid action to improve returns by managing loan growth and costs. The stock’s very low valuation - around 0.5x book value - appears to reflect historic execution issues, rather than its forward-looking earnings potential.

We also added to our holding in Conduit which appears set to benefit from a hardening reinsurance market, supporting our confidence in management’s ability to achieve the returns targets it set out at its IPO in 2020. Please see the Annual Report for examples of our engagement with investee companies which begins prior to purchase.

Sales

We reduced some of our Resources holdings, attempting to manage the trade-off between portfolio income and risk, after strong performance linked to the surge in energy prices caused by Russia’s invasion of Ukraine. We took some profits in BP and Shell, our two largest holdings, managing down their position sizes. We also trimmed our weightings in Rio Tinto and BHP where weakness in the Chinese real estate sector created a difficult backdrop for their main commodity, iron ore.

This was another busy year of M&A for the portfolio. Following bid announcements, we sold our holdings in DWF and Industrials REIT, both of which received offers from private equity at a sizeable premium. We see this M&A activity as a sign of the intrinsic value in this portfolio. We also took action to sell some of the lower yielding stocks in the portfolio, including Coca-Cola Hellenic, Mondi and Playtech, seeing more attractive income opportunities elsewhere in the UK market.

Outlook

The narrowness of market returns, both in the UK and globally, was the most striking feature of the period under review. In a large number of the world’s stock markets, index performance has been led by a small number of very large cap stocks. Most notable is the US market, where the “Magnificent Seven”, the group of headline-grabbing technology companies, including Amazon, Apple, Microsoft and Tesla are worth more than $11 trillion (greater than the combined market capitalisation of the Japanese, UK and German stock markets). The UK has seen a similar, if less pronounced, shift towards large cap stocks, for two key reasons. First, concerns about the risk of a global recession have driven investors towards the largest, most liquid internationally-focused stocks in each sector, at the expense of small and mid-cap domestically-orientated stocks. Second, UK equity funds have suffered a prolonged period of outflows, as investors sell down UK equities in favour of other asset classes. This has created a circularity in which negative share price momentum has fuelled the perception that the UK is an unattractive market, causing a reduction in liquidity and depressed valuations. In some cases, low valuations have triggered bids for UK companies, resulting in a shrinking number of companies listed on the UK market. According to Peel Hunt, the number of companies (ex-investment trusts) listed on FTSE has fallen from 504 in 2013 to 412 in 2023. For those companies that remain listed, there is often a frustration that their long-term prospects are not reflected in their valuations, driving a sharp pick-up in buyback announcements.

Against this backdrop, we have retained our focus on income, providing shareholders with a high level of dividend yield through a portfolio of attractively valued UK-listed stocks from across the UK market. We have constructed the portfolio across 3 key baskets of stocks. Each of these baskets provides different characteristics that should perform at different points in the cycle and help the portfolio to achieve each aspect of our investment objective.

Our focus on valuation is a key aspect of our investment process. We believe that the importance of valuation can come to life when managing an income portfolio. A simplified way of visualising the valuation attractions of an income stock is to consider the stream of dividends it is set to pay in relation to its share price. This can provide some perspective on what is being priced in, allowing a judgement to be made on whether the stock is attractively valued. For example, in its latest financial year Rio Tinto paid out 407p/share in dividends versus its year-end share price of 5174p, which equates to a dividend yield of over 7.8%. The market is clearly pricing in a rapid fade in dividend payouts, despite Rio Tinto owning high quality mines that will endure for decades. In another example, Thungela Resources, we made back our original investment in dividends within two years of purchase.

If you also include share buybacks, in addition to dividends, to calculate a stock’s overall distribution yield, then it becomes even clearer how rapid the payback period can be. At the pace of share buybacks being made by some of our holdings, the entire share capital would have been retired by the mid-2030s. Of course, there are always risks to every business that could erode profitability, de-railing dividend or buyback plans. We consider these risks when making a judgement on each stock we analyse, assessing what level of cash flow is likely to be sustainable in the context of the competitive position of each business. We discuss with management teams what percentage of those cash flows they expect to pay out in the form of dividends and/or buybacks. At the time of writing, the median free cash flow yield in the portfolio is 9.9%. All of this increases our understanding of the dividend prospects of the portfolio, strengthening our confidence in our ability to maintain a growing dividend per share to our shareholders.

Historically dividends have tended to represent a very high proportion of total return (Goldman Sachs calculate 65% over a rolling 20 year period in UK equities). We expect that, in a world of higher interest rates, investors should logically be more attracted to value stocks that pay out dividends now, rather than growth stocks that promise returns in the future. Higher discount rates make future cash flows worth less, when discounted back. We believe that this will drive an adjustment in the market’s perception of the attractions of value stocks versus growth stocks. The market is slowly acknowledging that interest rates are unlikely to go back to the extremely low levels seen during the 2010s. This should challenge the view that market leadership can revert to the quality growth stocks that led the stock market during that decade. As this becomes more widely recognised by investors, we would expect it to help catalyse a valuation re-rating of the cash generative stocks that we own in the portfolio. At the time of writing, the portfolio has a median Price/Earnings ratio of 9.0x and a median Price/Book ratio of 1.0x which compares favourably with 11.8x and 1.6x respectively for the FTSE All-Share ex Investment Trusts Index despite returns that are in line with the wider market (median Return on Equity of 11.7%).

In conclusion, our investment approach provides us with the flexibility to invest across the UK market to build a portfolio that is delivering a high yield and a growing dividend, while offering the potential to deliver NAV growth as earnings growth picks up and valuations re-rate. In the short term, the frustration is that subdued economic growth is causing a period of low activity levels across a range of sectors. Coupled with ongoing asset allocation shifts away from UK equities, this has so far inhibited a valuation re-rating in our holdings, thereby holding back our NAV/share. However, we are confident that this will change in time, as companies are rewarded for using this period to set their house in order, taking actions to improve profitability, while distributing capital via dividends and buybacks. We see the Company’s high yield as a function of the unusual level of opportunities available at this time, and we therefore look forward to the coming year with confidence.

Important Information

Risk factors to consider before investing:

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. Find out more at https://www.abrdnequityincome.com/en-gb/ or by registering for updates. You can also follow us on social media here: X (Formerly Twitter) and LinkedIn.