Market Overview

The Company’s reference index, the Russell 1000 Value Index, delivered a total return of -1.0% in sterling terms over the six month period ended 31 July 2023. The strength of sterling in the period more than offset the 3.5% local currency total return of the index. A combination of higher interest rates and inflation – due in part to a robust employment market – led to continued volatility in US share prices over the period. This is evidenced by the banking sector turmoil in March 2023 when two regional banks, Silicon Valley Bank and Signature Bank, both collapsed. There were several reasons for the failures; however, a key determinant was higher interest rates forcing both banks to lower the value of their investment portfolios. Faced with a US economy that has maintained positive momentum despite a succession of rate rises since March last year, the Federal Reserve (Fed) continued to tighten policy over the remainder of 2022. This included four successive rate hikes of 75 basis points (bps) between June and November 2022. However, with inflationary pressures moderating, the Fed then eased the pace of rate increases from 50 bps in December 2022 to 25 bps from its February 2023 meeting onwards. In fact, the Fed refrained from tightening policy altogether at the June 2023 meeting; however, the rise of 25 bps in July 2023 took the targeted Fed funds rate to 5.25-5.50%, its highest level since 2001. US stock markets rose steadily during June and July 2023. This was after investor sentiment was helped at the end of May 2023 by the long-awaited news of an agreement over temporarily suspending the US debt ceiling until January 2025, thereby reducing the risk of a US debt default. The communication services, information technology and industrials sectors were the strongest performers within the Russell 1000 Value Index, while the real estate, healthcare and utilities sectors were the primary market laggards for the period. The technology sector performed strongly amid rising investor demand for artificial intelligence (“AI”)-related stocks and the prospect of less monetary tightening in the future. The communication services and industrial sectors were also leading performers within the Russell 1000 Value Index. Conversely, the real estate, healthcare, and utilities sectors were the primary laggards for the period. 

Revenue Account 

The currency effect flows through the balance sheet and the revenue account, muting the sterling value growth as compared to the local currency performance. This year the trend of year-on-year growth in dividend income has checked slightly as investee companies have reacted to the tightening fiscal environment. Dividend income in the first six months of the year was £8.8m, or 3.8% lower than the £9.2m earned in the six months to July 2022. The marginal reduction in dividend income was offset by an increase in deposit interest as cash is now generating a more meaningful return than has been the case for many years. Option income was also down 5.6%. Dividend income is still almost 15% higher than the prepandemic income in July 2019 and our forecast for the second half of the financial year is that income will be close to the level earned last year. Total costs for the period have increased by 5.8%, with a reduction in the management fee, due to the decline in the underlying asset values, being outweighed by a rise in administrative expenses. 

Investment Performance

The Company generated a NAV total return of -3.2% for the six months ended 31 July 2023, underperforming the - 1.0% total return of the reference index, the Russell 1000 Value Index. 

Discrete Performance (%)

At a sector level, the main detractor from the Company’s performance was industrials due to stock selection and, to a lesser extent, having an underweight exposure to the sector. The second-largest detractor was stock selection in the materials sector. Looking at individual stock contributions, the largest individual detractor was a lack of exposure to the social media and technology conglomerate, Meta Platforms (“Meta”). Shares in the Facebook owner surged as the company reported better-than-expected earnings in the second quarter and issued optimistic guidance as the company is investing heavily in AI, a move which has been well received by investors. Non-dividend paying technology companies, like Meta, do not fall into our stock selection criteria as they do not return money to shareholders via dividend payments. Looking at stocks held in the portfolio, agricultural sciences company FMC Corporation underperformed, after the company reported disappointing second quarter earnings and lowered its full-year guidance, given lower-than expected volumes due to inventory destocking from its customers. 

Diversified healthcare provider CVS Health was another weak performer as it faced a challenging macroeconomic environment and above-trend claims from its Aetna insurance segment. In terms of positive contributors, at a sector level, the largest contributors to the Company’s performance were energy and information technology, both due to stock selection. Semiconductor manufacturer Broadcom was among the top positive contributors, performing strongly, alongside NVIDIA and other companies with AI exposure, after reports indicated a significant increase in demand for AI solutions. Broadcom subsequently reported earnings that confirmed these improving demand trends. Oilfield services provider Baker Hughes also fared well after it was awarded a major subsea equipment contract off the Ivory Coast. The company will supply several technologies to Africa’s first net-zero emissions development project. You can read more about Broadcom and Baker Hughes, and our rationale for holding them in the portfolio, on pages 15 and 16. Real estate investment trust Omega Healthcare Investors reported better-than-expected earnings thanks to higher occupancy rates at its customer facilities, along with fewer staffing issues. At the same time, the company’s management continues to make progress on restructuring certain customer contracts, a process which should conclude over the coming quarters.

Portfolio Activity

Our investment process focuses on identifying and investing in high quality, cash-generative businesses. Market volatility created opportunities to add quality companies into the portfolio at compelling prices. During the six month period, we initiated positions in three new companies. Beverage firm Keurig Dr Pepper has products in both the cold drinks segment (led by the flagship Dr Pepper brand) and the coffee segment, following the merger with Keurig which is a leading brand in the single-serve coffee segment. Historically, the cold drinks business has grown in line with, or above, the market, benefiting from the company’s strength in non-cola flavours and its status as a preferred distributor and acquiror of niche brands. The single-serve coffee business has recently been under pressure due to the impact of higher inflation but has excellent long-term trends and pricing in both segments (especially coffee) has now normalised, while demand strength and market share gains have continued. We also introduced Essential Utilities, a diversified utility with two-thirds of its earnings from the water business and one-third from the gas business. In the short run, the gas business should grow faster given the infrastructure upgrades needed. However, the water business should grow at a comparable pace over the intermediate term due to several small acquisition opportunities given that around 85% of the country is served by small, privately run municipal operations. Furthermore, environmental regulations continue to be more stringent and these incremental costs – some of which can be quite sizeable – are a common catalyst for acquisition opportunities. Another new holding is energy infrastructure company Enbridge. It is a premier midstream company that operates one of the most advantaged oil pipeline networks in North America, a strong collection of natural gas infrastructure and utility assets, and a growing renewable energy platform. The company’s diversified asset portfolio generates predictable cash flows thanks to its regulated and long-term contracts with customers. The strategy is to harvest this substantial cash generation to complete Enbridge’s large backlog of low-risk projects. Over time, project completion should drive earnings higher while also supporting the company’s shareholderfriendly distribution policy. Meanwhile, we sold clothing company VF Corporation. Despite having a portfolio of well-admired brands like Vans and The North Face, the company has faced multiple setbacks due to its continued poor execution. While many of these issues appear to be temporary, with most of them stemming from the pandemic’s effects on both supply chains and demand, they have impacted VF Corporation’s balance sheet. Moreover, any improvement in operating performance has likely been delayed while a new CEO attempts to reposition the company at a time when consumer sentiment is already weak. We also sold our position in energy infrastructure firm TC Energy, using the proceeds to fund our investment in competitor Enbridge. While both are still high quality energy infrastructure companies, we believe the fundamental backdrop favours Enbridge. TC Energy is in the process of completing several large projects that will create longer-term growth opportunities. However, factors primarily outside the company’s control have created delays and put upward pressure on costs, negatively affecting project-level returns. Furthermore, because of these pressures, TC Energy has set ambitious divestiture goals to fund these projects and now risks balance sheet degradation if these sales are not completed at fair prices in a reasonable time frame. 

A list of investments in the portfolio can be found on pages 12 to 13 of the annual report.  Within the Company’s corporate bond portfolio, we initiated several positions over the review period to take advantage of more attractive valuations. This was after these bonds’ yields became more attractive due to further monetary tightening as well as worries about what an economic slowdown could mean for the instruments’ credit quality. In contrast, we exited some other positions as the valuation of these bonds traded through what we deemed to be their fair value. We continue to work closely with the Manager’s fixed income specialists to monitor credits and market conditions. Outlook The US economy continues to surprise to the upside. After the latest interest rate increase in July 2023, consensus is shaping up that the Fed may be at the end of its interestrate hiking cycle. However, this view may be premature as core inflation data continue to be slow to contract and the Fed has been clear that it is committed to hitting its 2% target. Moreover, gasoline prices have been rising recently, which will negatively affect future inflation data. Up to now, the consumer has held up remarkedly well; however, higher gasoline prices, tighter lending conditions post the averted bank crisis and restarting student loan repayments are likely to constrain spending. That being said, the abrdn ‘house’ view remains that a mild recession is still likely. We now expect it to begin in the first quarter of 2024 and we are not forecasting a recovery until the tail end of the year. 

Important information

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