Market Review

UK equities advanced over the six months to 31 March 2024 as investors expressed relief over the receding risk of a hard landing for the economy, as falling inflation raised hopes of interest rate cuts later in the year. The start of the period was characterised by nervousness over the resilience of the global economy against the backdrop of elevated interest rates and geopolitical tensions. UK consumer spending remained subdued throughout the period, reflecting cost of living concerns after a prolonged period of high inflation. GDP data for the final quarter of 2023 confirmed a second consecutive quarterly contraction in output, signalling that the UK fell into a mild technical recession in the second half of the year. The market brushed off this news, focusing instead on the reduction in inflation from 6.7% in September 2023 to 3.2% in March 2024, at the same time as a robust jobs market supported UK wage growth running ahead of inflation. This raised the prospect of accelerating GDP growth later in the year. Elsewhere, the strength of the US economy continued to surprise investors, with the US Federal Reserve providing a further impetus to sentiment by signalling a change in monetary policy in November 2023. This helped to persuade investors that a hard landing for the US economy could be avoided. The success of the US economy was in sharp contrast to China which was held back by an ongoing slump in the real estate sector. Geopolitics remained febrile with investors' nerves tested by tension in the Middle East and the ongoing conflict in Ukraine.

Towards the end of the period, rate cut expectations were pared back, especially in the US where inflation data remained sticky, leading to higher Treasury yields. Around the world, growth stocks continued to outperform value stocks, while cyclical stocks outperformed defensive stocks. The US equity market continued to outperform that of the UK, helped by the heavy weighting in Technology stocks at a time of intense interest in Artificial Intelligence. European equity markets benefited from their heavy weightings in Industrials, Technology and Healthcare stocks. Late in the period, the UK equity market gained some support from a reversal in commodity prices following more encouraging industrial data from China, while oil prices moved higher on concerns over the potential escalation of conflict in the Middle East. The domestically focused FTSE-250 Index was supported by hopes of imminent rate cuts, outperforming the FTSE-100 Index during the six months, although its outperformance tailed off towards the end of the period as the prospect of early interest rate cuts receded.

Revenue Account

Total income generated by the portfolio in the period under review increased by over £650,000 or 13.9% to £5.4 million. We remain confident that the second half of the year will generate more than 60% of the total income for the period. This is the experience of the last 10 years to differing degrees and is as a result of many of the holdings declaring their final dividend for their previous financial year after our period end. The contribution from special dividends remained low at 3.7% of the total cash dividend income. We note that share buybacks, rather than special dividends, remain the preferred method of distributing surplus capital. This partly reflects the view amongst management teams that unusually low valuations make these buybacks particularly accretive to earnings. We note that 19 of our holdings, representing 45% of the portfolio, have undertaken a share buyback so far during the current financial year. Net revenue earnings for the six month period were £4.3 million, or 6.0% higher than last year's £4.1 million.

We calculate that the portfolio is expected to deliver a gross dividend yield, before costs, of around 6.9% based on the income expected to be generated by the portfolio over this financial year divided by the portfolio value at the period end. While this is lower than it was at the end of the last financial year it continues to represent a significant premium to the dividend yield of the reference index of 3.8% as at 31 March 2024. Elevated interest rates are unhelpful for our investment return as they reduce the gap between the rate we pay for the bank facility and the dividend yield we earn on the portfolio, although we note that money markets are now factoring in rate cuts in late summer. We continue to focus on identifying stocks that could help us deliver on the yield aspect of our investment objective, while also providing dividend and capital growth over time.

The focus on portfolio income is consistent with our investment process given the emphasis we place on finding companies whose cash flow and dividend potential are not effectively priced in by the market. We are aware of the challenges facing income investors, notably the preference among management teams for share buybacks over special dividends, as well as the prolonged period of geopolitical and economic uncertainty. Looking ahead, we expect many UK stocks to be able to accelerate dividend growth once this uncertainty starts to ease. This would help to reduce the concentration in dividend payments among a handful of sectors that has resulted from the unusual macro backdrop since Covid. Our index-agnostic approach allows us to consider a wide range of stocks, across the UK market, with many different drivers of earnings. We have worked hard during the period to seek out companies with strong dividend prospects from a broad range of sectors, helping to diversify the portfolio's income.

Portfolio Performance

The Company's net asset value ("NAV") total return was 1.6% for the period. This was behind the total return of 6.9% for the Company's reference index. Performance during the period was largely the result of stock-specific drivers.

The percentage growth figures are calculated over periods on a mid to mid basis. NAV total returns are calculated on a cum-income basis. Past performance is not a guide to future results.

Within the Financials sector, Close Brothers fell on concerns over the risk of sizeable customer redress following the announcement of an FCA review into historic motor finance industry lending practices before 2021. Shortly after this decision, the Company announced that it would waive the dividend, reflecting its priority to build capital and so allay any market concerns over capital adequacy in the event of a harsher than expected outcome from the review. The shares subsequently retraced some of the losses, helped by results that indicated solid trading in their Banking and Asset Management divisions.  

Within the Energy sector, a backdrop of falling commodity prices for most of the period was unhelpful for some of our holdings. Diversified Energy declined as a collapse in the US natural gas price impacted cash flows, ultimately leading to the decision to cut the dividend in order to increase the balance sheet flexibility, enabling them to continue making accretive acquisitions, while paying down debt. The stock subsequently rallied as investor confidence in the balance sheet outlook improved. Thungela Resources declined in response to falling thermal coal prices, although results revealed that it remains highly cash generative, providing the management team with optionality on use of capital and supporting the share price. The return of M&A activity helped performance in DS Smith (see the Case Study following) as the share price reacted positively to the announcement of rival bids for the company from International Paper and Mondi. We had identified DS Smith as an example of a business that was of far higher quality than the valuation implied. DS Smith had struggled to close the gap with its global paper and packaging peers, but this bid situation highlights the role that can be played by M&A in correcting these valuation anomalies. Finally, performance relative to the index was impacted by the strong performance of lower yielding large cap growth stocks RELX, Rolls-Royce, 3i and Experian, although this was partially offset by the weak performance of defensive consumer stocks Unilever and Reckitt Benckiser.

Activity

During the period we intensified our focus on identifying investment opportunities that can help to deliver on each aspect of our investment objective. We seek individual stocks that can exhibit a combination of dividend yield, dividend growth or valuation re-rating. Sometimes we find stocks that have the potential to deliver all three of these attributes. We see current market conditions as particularly conducive to finding such stocks, given the long period of valuation de-rating experienced by many UK companies, in particular small and mid-cap companies. It is unusual for the mid-cap index to be trading at a similar yield to the large-cap index. As a result, we see the current period as benign for our index-agnostic investment approach, with a potential kicker to returns as improving investor sentiment drives a re-rating in valuations, alongside dividend yield and growth. As a reminder, a key feature of our investment process is the identification of stocks that offer positive catalysts that can drive a valuation re-rating.

Current market conditions are therefore supportive in allowing us to identify opportunities across a broad range of sectors, helping to diversify the portfolio's income. Notable examples of some of the largest purchases during the period include: - Assura: We initiated a new holding in Assura, the primary healthcare property group. We last owned this stock in the portfolio in 2021, selling the stock at a large premium to its NAV, since which time the share price slipped below its NAV as a result of higher interest rates. Operationally the business remains strong, with evidence of attractive rental growth and a pipeline of new developments. - Sirius Real Estate: We bought a new holding in Sirius Real Estate, the multi-let real estate business, taking part in a placing. We see potential to use the funds to acquire attractively valued assets onto the existing platform, driving up income. - Energean: We built a new position in oil and gas business Energean, which operates mainly in the Mediterranean where it is growing production rapidly and building long-term gas contracts that insulate against commodity price volatility. Rising geopolitical tension is increasing awareness of the need for energy security, especially in Europe. - M&G: We started a new holding in M&G which is using strong cash generation from its life business to invest in new sources of growth while paying a very attractive dividend.

The high dividend yield implies that the market is not efficiently pricing in further success in these growth initiatives. - Imperial Brands: We added to our existing position. We note that since the arrival of a new management team, the business has consistently delivered on the profits guidance they provide to the market, focusing on getting the operational basics right. Earnings growth is underpinned by a large share buyback, with over £600 million of stock bought back in the first half of their current financial year, equating to nearly 8% of the shares in issue on an annualised basis, in addition to the 8% dividend yield. These purchases were funded by profit-taking in some larger cap stocks that had rallied strongly on the improving macro outlook, as well as some mid or small-cap holdings where our process has led us to conclude that the investment thesis may have weakened due to a lack of imminent catalysts. Notable examples of our largest sales include: - Glencore/Shell: We moderated the position size, in both cases managing the trade-off between portfolio income and portfolio risk, redeploying the proceeds elsewhere. - Barclays/NatWest: We took some profits following a very sharp rally in the share prices, as investors became more positive on the sector, recognising the brightening outlook for net interest income and feeding through to upgrades to return on equity forecasts. We reinvested some of the proceeds in HSBC and Standard Chartered, which had lagged. - Bellway/Vistry: We sold our holding in Bellway towards the end of the period, after the shares had rallied strongly in response to falling mortgage rates. We sold our holding in Vistry earlier in the period following a change in dividend policy. - Hays: We sold the holding as the macro-economic backdrop was unhelpful, with a mismatch between candidate and employer confidence causing a slowdown in hiring activity.

Outlook

The period under review was characterised by gradually improving investor sentiment, despite ongoing geopolitical tensions, as the risk of a hard landing for the global economy was perceived to be receding. The market backdrop was initially challenging given the market's preference for growth stocks over value stocks, but market conditions became more benign later in the period as market leadership began to broaden out. After troughing in mid-February, our NAV performance picked up sharply as the results season unfolded, providing catalysts for our holdings to unlock the value that is latent in the portfolio. A prolonged period of scepticism on the macro outlook has driven down expectations, paving the way for a sharp recovery in share prices, analogous to a coiled spring, on the first hint of more positive news. As valuation re-rating comes through, it can be extremely powerful for our NAV, especially when coupled with earnings and dividend upgrades. A further benefit of a recovery in the NAV is that it provides an increased capital base from which to generate portfolio income. The full year earnings season (February-April) tends to be the richest period of the year for our team in generating investment insights, as this is when we are most busy meeting company management teams, writing stock notes and collaborating, providing a decent pipeline of new investment ideas for the portfolio.

As I explained in the Activity section, we have continued to use our investment process to position the portfolio in stocks where we see the potential for a combination of dividend yield, dividend growth and valuation re-rating. A more stable macro backdrop would increase the number and breadth of stock opportunities offering all of these characteristics, but we are working hard to ensure that the stock-specific catalysts that we have identified are robust enough such that our portfolio is not dependent on an improving macro backdrop. The scale of the valuation opportunity can be seen from the gap between the valuations of our holdings and those of the wider market. At the time of writing, the portfolio has a median Price/Earnings ratio of 9.4x and a median Price/Book ratio of 1.2x which compares favourably with 12.1x and 1.6x respectively for the FTSE All-Share (ex Investment Trusts) Index. Valuations can seem to be an abstract concept, but they come to life when thinking about the dividend yields available, the buybacks being pursued by management teams hungry to take advantage of low valuations to hoover up shares or the surge in inbound M&A activity taking hold as the gap between UK valuations and global valuations becomes too wide for overseas companies to ignore. In conclusion, we are now increasingly confident that the clouds that have existed for some time are now dissipating, with many of our holdings now delivering on the investment thesis we originally anticipated at the time of purchase. In the second half of the Company's financial year, we will strive to build a portfolio that can deliver for shareholders both an attractive level of portfolio income and a sustained NAV recovery.

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