Portfolio Strategy

We take a long term approach to investing, believing that, whilst there might be volatility in the short and even medium term, share prices will ultimately reflect the fundamental value of a company. Consequently, there was no change to our approach to the construction of the portfolio during the year under review. The Company’s investment portfolio continues to be invested in equities and preference shares. At the year end, 80% of the portfolio was invested in equities and 20% was invested in preference shares.

Equity Market Review

The year to the end of March 2024 was a good one for equities, with the MSCI World Global Index delivering a total return of around 25%, well ahead of the long term average. This return was heavily weighted to the second half of the year. The market move has generally tracked inflation and therefore interest rate expectations, with valuations improving once investors had a line of sight on the peak of inflation and interest rates. By geography, the US performed well, with a 30% return from the S&P 500 Index and an even more impressive 40% gain for the technology focused Nasdaq Index. Europe, returning 15%, and the UK, 8% were comparative laggards. Emerging markets were also relatively weaker, returning 8% in aggregate, although there were distinct winners and losers within that: the MSCI China Index returned a negative 17%; the MSCI India Index returned a positive 40%, highlighting the stark difference in investor positions of these two economies over the period.   The above performance data highlights the significant outperformance of the US in developed markets and particularly of the group of large cap technology companies known as the “Magnificent Seven”. These companies have been direct beneficiaries of accelerated revenue growth due to the early adoption of artificial intelligence technologies alongside increased investor optimism on the sector. They have also been natural beneficiaries of investor expectations that interest rates have peaked and will begin to fall in the second half of 2024 (more on this in the Outlook section below). In contrast, European and UK markets, which have a lower weighting to technology and growth companies, have relatively underperformed.   “The NAV total return for the year  was 5.1%, lagging the FTSE All-Share Index which returned 8.4%. This performance is roughly in line  with what we would expect in  these markets.”  Within the UK market, technology also performed well, with the sector returning 35%. The problem was that with a weighting of only 1.4% in the FTSE 350 Index at the end of the year, it was not enough to drive the wider market. Other sectors that performed well were Industrials (+27%), Financials (+14%), Consumer Discretionary (+13%) and Energy (+11%). These were offset by weaker returns from Telecoms (-13%), Consumer Staples (-6%), Basic Materials (-5%) and Utilities (flat on the year). In general, the UK’s weighting to some defensive and income  sectors meant it failed to keep up with a rapidly rising global market. The UK market ended the year on a material valuation discount to global markets – roughly a 40% discount on a price to earnings multiple. While much of this is justified by the lower growth from the UK’s sectoral exposure, the discount remains around 20% once we adjust for this.   

Investment Performance

The equity portfolio returned 5.1% over the 12 month period, lagging the FTSE All-Share Index which returned 8.4%.

Total return; NAV cum income, with 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.

This performance is roughly in line with what we would expect in these markets. The equity portfolio is defensive and weighted to higher income sectors, so can lag a rising market. That being said, stock section in the year detracted from portfolio returns and that was disappointing. After taking into account the performance of the preference share portfolio (see below) and adjusting for costs, the net asset value (“NAV”) total return of the Company was also 5.1%.  On a stock specific level, there were a number of strong performers in the portfolio. Intermediate Capital, a private equity fund manager, delivered robust performance and flows, with its shares rising by 78%. The exposure to banks performed well as returns improved, benefitting from higher interest rates and low credit write-offs: NatWest’s shares increased by 31% during the period and Standard Chartered increased by 16%. Industrials generally performed well as economic activity remained robust and valuations recovered. Melrose Industrials (+65%) re-rated after spinning out its lower quality autos business and Morgan Sindall (+45%) delivered continued growth as its fit out and construction businesses performed strongly. Finally, the addition of a number of small cap UK companies around the middle of the year also had a positive impact as these responded well to robust results and falling interest rate expectations. Hollywood Bowl (+24%) and 4Imprint (+46%) performed particularly well.   Offsetting this, the portfolio suffered from holding a number of companies that disappointed in the year for fundamental reasons. XP Power, which provides power supply to high tech manufacturing, fell by 61% after issuing a profit warning as end clients de-stocked. This was particularly disappointing, coming only a matter of weeks after management had reassured on the outlook for the business. XP Power was one company that fell victim to a lack of visibility in client orders as many industries went through a de-stocking cycle, having built up inventory during the pandemic period. Dr. Martens (-36%) faced similar issues, with high inventory levels in US wholesalers and supply chain challenges causing downgrades to expectations. Another cyclical disappointment was Genus, with its shares down 40% due to weakening demand for pork in China.  Close Brothers fell by 51% after the announcement of an FCA review into auto lending in the UK, although we feel the impact of this is overstated. Some commodity companies also suffered from falling prices: Anglo American fell by 24% due to lower metals prices and disappointing production figures, while Diversified Energy fell 40% due to a sustained fall in the US gas prices to very low levels. Given its weighting in the portfolio, the fall in Diversified Energy had a meaningful impact on the portfolio, detracting 1.4% from performance over the year.

Gearing and Preference Share Portfolio

The total return from the preference share portfolio for the year was 16.1%, with yields compressing as interest rate expectations began to move lower. This performance is very much as expected – during a period of rapidly rising interest rates we would expect the bond like characteristics of preference shares to mean they decline in value, and in an environment when interest rates are falling we would expect this to provide a boost to the portfolio. Our view on the long term attractions of the preference shares has not changed. From here onwards it is more likely that interest rates eventually decline gradually, acting as a modest tailwind for the valuation of this part of the portfolio. Secondly, the attraction of these instruments is their high, dependable yield. This has not changed and the preference share portfolio offered a forward yield of almost 7% as at the year end. “The total return from the preference share portfolio for the year was  16.1%, with yields compressing as interest rate expectations began to move lower.”  The gearing level at the year end was 16.4%. The Company’s borrowings are notionally invested in the preference share portfolio. At the year end these securities had a value of £24.2 million, materially in excess of net indebtedness which stood at £17.3 million.

Revenue Account 

Revenue earnings per share were broadly flat at 14.75p. While the income generation of the portfolio in absolute terms has continued to increase, the aSCIT transaction in December resulted in an increased share-count. We expect the impact of this to be limited over time, but the timing of the transaction meant that we received a number of holdings from aSCIT which did not pay dividends during the remainder of the financial year, resulting in a short term shortfall in income. We remain optimistic on the income growth potential of the portfolio over the longer term. 

Portfolio Activity

Over the course of the year, we remained active in the portfolio, adding 14 new positions and exiting 18. The number of positions in the portfolio therefore reduced and, despite the aSCIT transaction, we have maintained a reasonably concentrated portfolio, while diversifying sources of income widely. The aSCIT transaction allowed us to select, alongside the abrdn small-cap team, those holdings from the portfolio which best suited our requirements of income growth and long term capital growth. The result was a more concentrated and meaningful small-cap exposure than through our previous indirect exposure through aSCIT. We added five new names: Greggs is a growing UK food retailer with a strong market position and cost competitive offering; Hollywood Bowl is a well-run leisure company gaining market share in the UK and expanding internationally in Canada; 4Imprint is a digital business providing corporate marketing products and is winning market share in a fragmented industry; Bytes Technology is an IT re-seller with exposure to growing software demand; and Hunting is a high quality engineer focused on energy services and benefiting from increased visibility on sales as offshore activity recovers. In aggregate, these companies give us exposure to a diversified mix of quality and growth within the portfolio. Other additions reflected changing outlooks for some sectors. We added exposure to UK banks via Lloyds given the outlook for more resilient income as interest rates have normalised. We also added some modest real estate exposure after a period of weakness, adding Sirius Real Estate and Assura - two companies with strong management teams and track records of growing value and dividends. Our view that the aerospace sector had an improving outlook was reflected in a purchase of Melrose Industrials, which also re-rated after the spin out of its lower quality auto business. “We remain optimistic on the income growth potential of the portfolio over the longer term.” We also reflected changes in our analysts’ preference by switching holdings within sectors. For example, we replaced Smith & Nephew with Convatec given our view that there was more margin improvement and end market growth to come from Convatec in the near term. In the banking sector, we switched Nordea into ING given the more defensive nature of the business and a preference to move away from Nordic banks after a strong run and higher valuations. Also overseas, we continued to look for ways to diversify income, adding Mercedes-Benz, where the valuation looked very attractive and Enel which gives exposure to diversified utilities and strong capital growth from energy transition in its end markets. Exits during the year primarily reflected changes to our view on the fundamental value of the businesses. RS Group, Howden Joinery and Coca-Cola Hellenic all performed reasonably well and reached levels where we saw more limited upside compared to other holdings. For Diageo and British American Tobacco we had some concerns around the potential for revenue growth in the near term and decided to move onto higher conviction ideas. Sales of Vistry, Urban Logistics, Nordea, Bawag and Smith & Nephew reflected a preference for other companies in the same sectors. Veterinary pharmaceuticals producer Dechra Pharmaceuticals was sold after the company was bid for by a private equity firm at a healthy premium. 

In most cases of disappointing performance we chose to hold onto the positions, taking the view that the long term quality of the businesses remained and a lower price reflected short term changes in outlook. However, we did sell out of XP Power after a profit warning and Direct Line Insurance following a dividend cut, given decreased visibility on cash generation and the ability to pay a stable and growing source of income over time.  As usual, the preference share portfolio has seen limited change, although we did add two new fixed income investments issued by Standard Chartered and Lloyds. This enabled the portfolio to retain its weighting of around 20% to preference shares after the aSCIT transaction. Both positions offered around a 7% yield at the time of purchase, an attractive level relative to equities and with a higher degree of income protection in the long term.

Stewardship

We believe that, as long term owners of the businesses in which we are invested, it is not sufficient merely to seek out assets that we believe to be undervalued. It is also incumbent upon us to take a proactive approach to our stewardship of these companies. Therefore, we engage extensively with investee companies. We have attended a range of meetings with chairmen, non-executive directors and other stakeholders. Topics covered have included the composition of boards, environmental and social issues, and remuneration. Risk is a very broad subject that is interpreted in varying manners by different companies. However, by engaging on this subject we secure a deeper understanding of how the boards of investee companies perceive and seek to manage these issues. Such interactions also enable us to push for improved disclosure and better management practices and on occasion different decisions where appropriate. We have had conversations regarding companies’ financing choices. We find that it is always worthwhile communicating our preference for conservatively structured balance sheets that place a company’s long term fortunes ahead of possible short term share price gains. Such activity is by its nature time consuming but we regard it as an integral aspect of our role as long term investors. Consideration of Environmental, Social and Governance (“ESG”) factors forms an important part of our investment process. Whilst the management of the Company’s investments is not undertaken with any specific instructions to exclude certain asset types or classes, we embed ESG into the portfolio and sector specific research on all positions as part of the investment process. ESG investment is about active engagement with the goal of improving the performance of assets held by the Company. We aim to make the best possible investments for the Company by understanding the whole picture - before, during and after an investment is made. That includes understanding the ESG risks and opportunities they present, and how these could affect longer-term performance and valuation. ESG considerations underpin all investment activities. 

Outlook

The last 12 months have delivered positive NAV growth, increased scale and continued income growth for the Company. Performance has not kept pace with a rising market and that is, of course, disappointing, but we continue to focus on capital and income growth. Positions in defensive, income generating sectors, such as utilities have lagged faster growth areas of the market such as technology, but that does not mean they have been bad investments or that they will fail to deliver an attractive total return for investors over the long term.

Making forecasts for the next 12 months is always difficult, and especially at the moment. In the last three months we have seen interest rate expectations move back and forward, with global markets pushed to new highs before retreating again. At this time, it seems that interest rates will need to stay higher for longer to counteract inflation and continued strong growth from the US economy - but which direction we will be heading a year from now is hard to guess. Economic policy and market sentiment is very data dependent, and the data can change quickly. The added complication of a record year for democratic elections globally, including the US and the UK, makes the outlook even cloudier. Stretching our time horizon perhaps makes the task easier. Interest rates are higher than they have been for some time and although they are not going back to the extreme lows we have seen in the last decade, the likelihood is that the direction of travel is back towards an equilibrium rate of 3-3.5% within our investment timeframe. Rates at that level should allow for a more normal market, with equity performance broadening out, something we have started to see in March and April 2024. Market performance in the past year has been unusually concentrated - history would indicate that is unlikely to remain the case forever. Similarly, the discount on UK equities is historically high, providing a margin of safety. Without a re-rating of the benchmark index we will continue to see UK companies acquired by  international peers. The portfolio has performed well in the past few months and our expectation would be that a focus on capital and income growth will deliver results over the long term. We also expect a reduction in interest rates to increase the relative appeal of the proposition. Currently, investors can earn an attractive return on cash deposits and that has led many to understandably take a “risk-free” approach in allocation. The Company’s dividend yield is already superior to cash, while also providing the prospect of capital growth and a hedge to inflation, but as deposit rates reduce it is likely that a high level income will become more appealing again. 

Important Information

Risk information 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.