Dunedin Income Growth Investment Trust : The UK's reputation problem

The UK's turbulent politics have had repercussions in bond and currency markets. This is potentially destabilising for stock market investors as well. Even though many UK companies source a large share of their earnings from abroad, sentiment can exert a drag on all UK assets. While Rishi Sunak's ascent to the premiership has calmed nerves it will likely take some time for investors to fully forgive the events of the past few weeks.

The biggest risk to the operational performance of UK companies from this volatility is around bond yields. Higher bond yields can influence the cost of funding for UK companies, raising costs for those with debt. This is a particular problem if a company relies on managing a 'spread' - where there are assets that generate an income that cannot be adjusted quickly, balanced with debt that needs funding and where the cost of that funding can rise. Commercial real estate would be a typical example. In this case, if bond yields rise, costs go up relative to income and margins will be squeezed.

Higher bond yields also potentially mean lower valuations for companies as the rate at which investors discount future cash flows increases, reducing the value of long dated future income.

Another area of potential stress is where companies rely on the provision of credit to support the sale of their products, such as the housebuilders or mortgage lenders themselves. There are vulnerabilities here too, as the housing market weakens.

In general, we avoid companies with high debt levels, so we aren't so worried about the impact on balance sheets for companies in the portfolio from rising bond yields. Amid the housebuilders, there are still sound structural growth drivers and often with significant cash piles. We are inclined to look for opportunities here rather than avoid them because share prices have been hit hard and there are a number of good quality, cash generative companies to consider.

The turmoil in UK politics is distracting, but it can distort share prices and open up a gap between a company's prospects and its share price. It may be uncomfortable at the time, but, with hindsight, moments like this often bring opportunities.

Resilient RELX

RELX has been a long-standing holding for DIGIT and we consider it a core position in the Trust. It is a provider of information services to three main end markets: scientific, technical and medical, legal and risk management. Its scientific publisher, Elsevier, publishes academic papers, a steady and consistent business that operates largely on a subscription model. This is highly profitable and not economically sensitive.

Its legal business is Lexis-Nexis. This sits alongside its risk division, which provides data and analytics services largely to insurance companies. Both these end markets are largely insensitive to the economic cycle and both have displayed consistent growth in recent years. The group has improved its margins, while also demonstrating some operational leverage and delivering a steady dividend. Its one weak spot has been its exhibitions business, which was hit hard by Covid, but is now seeing a recovery.

Overall, it's the type of business we like. It has good visibility on earnings, consistency of performance and is servicing end markets that aren't particularly sensitive to the economic environment. The long-term growth drivers are solid and it is a reliable cash generation engine for the portfolio.

M&A activity in the UK

The turmoil in the UK has seen considerable volatility in the Pound. Combined with a strong Dollar, it has left UK companies looking relatively cheap for foreign buyers. In normal circumstances, this would encourage merger and acquisition activity in UK companies, which would be a support for the share prices. We have already seen bids for a number of companies in the portfolio - publishing group Euromoney and industrial software company Aveva - and believe that we will see more activity further down the line.

However, the volatility of the UK's political situation is a deterrent. While a cheap currency will encourage buyers, it needs to be accompanied by a benign capital markets environment. While we are starting to see stability restored and some confidence returning, it may be some time before international buyers are tempted back. The exception would be the largest corporate buyers and deep-pocketed private equity firms, which may be willing to look through short-term difficulties.

As bad as it gets?

The turning point for financial markets is not usually when the environment suddenly becomes dramatically better, but instead when all the bad news is fully reflected in the price of assets. At that point, any incremental good news can move the price higher. With this in mind, there has been a question over whether all the bad news on the UK is now in the price of equities and a turnaround is imminent.

It is not a straightforward question. While larger UK companies are trading on reasonable valuations, in our view the real value sits in the mid-cap part of the market, particularly in the domestic-exposed companies widely shunned by investors. There are reasonable concerns about the UK economy with pressures on demand, costs going up and a generally difficult backdrop. However, on a three to five year view, it would seem a reasonable time to be taking some judicious risks.

The economic contraction lies ahead of us, but equity markets always look forward. Shares will bottom well before the economy. It is a moment to be tentatively re-examining UK equities, particularly those domestically-focused UK names that have been so out of favour.

Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.

Important information: Risk factors you should consider prior to investing:

• The value of investments, and the income from them, can go down as well as up and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company's assets will result in a magnified movement in the NAV.
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company's shares.
• The Company may charge expenses to capital which may erode the capital value of the investment.
• Derivatives may be used, subject to restrictions set out for the Company, in order to manage risk and generate income. The market in derivatives can be volatile and there is a higher than average risk of loss.
• There is no guarantee that the market price of the Company's shares will fully reflect their underlying Net Asset Value.
• As with all stock exchange investments the value of the Company's shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• Certain trusts may seek to invest in higher yielding securities such as bonds, which are subject to credit risk, market price risk and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate.
• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.

Other important information:

Issued by Aberdeen Asset Managers Limited, registered in Scotland (No. 108419), 10 Queen's Terrace, Aberdeen AB10 1XL. Authorised and regulated by the Financial Conduct Authority in the UK. An investment trust should be considered only as part of a balanced portfolio.

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