Cherry Reynard: Hello, welcome to today's podcast on the Dunedin Income Growth Investment Trust. I'm Cherry Reynard and with me today are the trust managers, Ben Ritchie, and Rebecca Maclean. We're going to be looking at the latest data on the UK economy and discussing the mood music from UK companies. So welcome, Ben. Welcome, Rebecca.

Ben, if we could start with you. At the start of the month, the IMF singled out the UK as the cloud in another wise quite sunny economic outlook for once. Has that influenced your positioning at all in recent weeks?

Ben: Well, thanks very much, Cherry, it's a pleasure to start the year with a discussion about the Dunedin with Rebecca and yourself.

So, the short answer would be no, not really, I don't think it makes any difference at all, to be honest. So I think there's always been historically a fairly tenuous relationship between GDP growth and the economic performance of companies. And I don't think that particularly changes. I don't think this does much for sentiment. Clearly, the UK economy does have some challenges. It's not alone in that. And it has had a tougher time in terms of rebounding from COVID. But at the end of the day, we keep coming back to this thing that 70% of revenues are coming from outside of the UK, when it comes to the FTSE All Share. And within it, we're always looking for businesses who are primarily driven by structural growth rather than cyclical.

Now, not every company can escape the sort of forces of the broader economy. But ultimately, we're looking for companies that do more than just GDP. And so even those that are exposed to domestic economic trends, we think can do quite a lot better. And then we've got a lot of the portfolio that doesn't have any exposure to the UK at all, or certainly any exposure to the sort of domestic cyclical angles. So overall, while the IMF, judgement is not helpful sentiment, and I'm sure does deter investors at the margins. And I think particularly international investors have been pretty wary of the UK and Europe for a number of years. I think for us investing in the market, it doesn't really make much difference at all. And if anything, if that continues to depress the valuation of UK equities, then that allows us to make better investments and better prices for the longer term as well. So, I think we're pretty relaxed overall.

Cherry: Yeah, absolutely. As you say, it's not like sentiment was really sort of hot anyway. And, Rebecca, I mean, what's the mood music from company management teams about the outlook for the next 12 months, you know, on things like input prices or wage rises? That sort of thing?

Rebecca: So we spoke to a number of management teams from the UK companies recently. And I'd say that broadly, the tone is probably that things aren't as bad as feared. So, I'm sort of thinking back to Q4 last year, you know, there certainly was concern around the UK consumer, given higher interest rates and inflation pressures. But what we've seen from reporting for a number of companies is that trading remains robust. So, indeed, within the consumer discretionary sector, we have had a number of reassuring updates. So the house builders, for example, are seeing sales rates pick up and this is as mortgage rates have eased, and indeed are holding in Taylor Wimpey is talking about near term uncertainty. But they remain confident about the medium term fundamentals for the business given supply demand dynamics and the company's strong cash position. And so they seem to be seeing an improving environment.

And then maybe thinking about the retailers. And we've had a number of decent updates from retailers too over the Christmas period, particularly those which have got low ticket items. So Pets At Home, which is a holding in the Investment Trust, delivered, a trading update, which pointed to strong trading momentum, and even in the discretionary parts of the, of the business around accessories for pets, they're seeing that business grow. So yes, certainly I'd say that things are not as bad as feared in the UK.

And then looking further afield. There's much more optimism around China following the removal of COVID restrictions. And we're seeing this benefit companies like Prudential which should see recovery following the reopening of the Hong Kong China border. So a degree of optimism in that market. So that's on the demand side.

And when it comes to costs, I think we're also sort of seeing some positive tones in terms of some easing in the rate of inflation, most notably in energy and in freight costs. Labour markets do remain tight in the UK and in the US. But we are seeing some easing of pressure, particularly in sectors like the technology sector. So I'd say that sort of broadly, there are pockets of weakness in a number of sectors, but we're seeing some signs of optimism.

And certainly, the pessimism and the market volatility, which was felt around the time of the mini budget, has receded.

Cherry: Okay, thanks. I mean, Ben, some of the sectors that Rebecca talks about, there, are sort of conspicuously mid cap sectors rather than the large cap sectors, which did so well in 2022. I mean, are there any signs that that sort of balance is readjusting and that small and mid-caps are bouncing back?

Ben: Well, I think if you look at the sectors that did well, I think it's less that the sectors themselves did well and that the economic drivers that they're exposed to were quite favourable. So 2022 was a good year for commodity prices, was a good year for oil and gas, was a good year for companies exposed to rising interest rates and as a result that drove good performance from banks, larger financials and oil and mining, which is, you'll know, pretty large parts of the UK market.

And then I think the weakness in Sterling also drove better performance again from some of the large international companies within the marketplace like Unilever, Diageo, pharmaceutical companies, tobacco, all of those kinds of things. So, in many ways, last year was really a sort of perfect year for the UK versus the rest of the world. So ironically enough, if you've spent too much time listening to the IMF, you don't invest the time when actually the drivers are pretty favourable for UK PLC. But one of the things I think we've noticed over the long term is that the performance of UK mid caps, and to some extent, the performance of UK small caps has actually been really rather good. So if you go back to Brexit, and track the performance of the FTSE 250, it's actually really been, it's really been pretty strong. And you would have thought that that doesn't really make sense, because that should be the part that's most exposed to the negatives of Brexit, but actually, the underlying performance of the companies there is continued to be very positive. Certainly, that took a knock with COVID. But we would think anyone taking a long term view on the UK market would think that probably the mid cap and smaller cap part of it is the area where they're going to be able to find the most interesting companies, the companies that are uncovered by others and then offer by extension at the most attractive returns and opportunities, and that doesn't necessarily mean the FTSE 100 versus the FTSE 250, Ii could be the bottom half of the FTSE 100 as well. But when Rebecca and I are looking at the portfolio, generally speaking, I would say the things that we're most excited about, don't sit in the top half of the FTSE 100. You know, there are companies which might be, you know, somewhere between 1 and 10 billion in market cap, and where we see, you know, attractive, sustainable long term growth both in revenues, profits, cash flows and dividends. And that doesn't tend to be at the mega caps within the index. And that's why we've been overweight, mid caps within DIGIT for many years. And I expect that we will continue with that type of position. And generally, when we've been adding stocks over the course of ‘22, it's been into more mid cap, or smaller FTSE 100 type companies like Hiscox, Oxford Instruments, and Sage. And that's where we see businesses with better growth potential, better return potential, versus some of those large cap mega stocks which have done pretty well in ‘22 and not bad in ‘21. But where we think the law of averages and actually the underlying economic performance of the companies sits in our favour, if we're looking away from that part of the market.

Cherry: And Rebecca, I'm zeroing in on the portfolio a little bit now. I know that you have both Volvo and Coca Cola as some of the Trust's largest holdings. I wonder if you could talk me through them and why you hold them?

Rebecca: Certainly, so Volvo manufactures and services, commercial trucks, and construction equipment, and we see the company as being a high quality company within what is a cyclical sector, with relatively limited visibility. But we're positive on the internal improvements that the company is making and what this means for the business. So, for example, it's looking to boost its services revenues. And this should be supportive for margins and returns in the future in addition to sort of improving the resiliency of the company's profitability. In the meanwhile, the company's got a strong balance sheet. And we think the company is attractively valued with the dividend yield, which is just shy of 6%.

And the second company you mentioned is Coca Cola Hellenic, which is the anchor bottler for Coca Cola in 29 countries across Europe and Africa. The company enjoys high barriers to entry given their contract with the Coca Cola company. And in addition, attractive growth prospects, given its exposure to faster growing emerging markets, where consumption per capita is below that of developed markets. We think that the company has got a good outlook for growth. And we think this isn't reflected in the discounted valuation where the markets concerned about the inelasticity of demand, and about the Russian assets, which its running at arm's length. So, we think that the company is got an attractive valuation, it's on about 13x price to earnings multiple, and this overly discounts that resiliency in and the potential to grow high single digits in the future.

We see the company as a ESG improver. So the key sustainability issue facing Coca Cola Hellenic is their sale of plastic bottles, which are made from virgin plastics into countries which have limited collection systems. And so, the company has set out targets to reduce its plastic content and increase recycled plastic. And this is something that we're going to be monitoring, and we will continue to engage with the company in order to encourage that transition.

Cherry: Now, Ben, there's been a pretty strong bounce back for UK dividends. But obviously, if the economy weakens, there could be some kind of vulnerabilities in the year ahead. I mean, how are you ensuring the sustainability of dividends in the portfolio? And what do you do if a company cuts?

Ben: Yeah, so it's a, it's a good question. I think Link who publish a sort of quarterly update on their expectations for dividend growth, are expecting the underlying dividend growth in 2023 of 1.7%, so just under 2% - we would hope the portfolio in aggregate will do a little bit, a little bit better than that. But we'll have to see how we get on over the year, certainly on an average basis, we would expect that companies in the portfolio to do better than that. But it does depend to some extent on the weightings and transactions and so forth, that happened during the year. But then we certainly think of sort of low mid-single digit growth rate for the portfolio is achievable. And that's what we think is a sort of sensible, long-term goal for us.

When companies cut their dividends, I think it depends why that's happening. I think sometimes that can be an opportunity to add more of an attractive price. And sometimes it signals something to people rather than more, rather than more concerning. So I don't think there is a, I don't think there is a rule of thumb for us. And if we look at Direct Line, which we own in the portfolio, they have announced that they are going to cut their dividend in order to shore up their capital position as a result of weather related losses and some investment losses that they've suffered, and arguably having run their balance sheet a little too thinly in terms of cover, you know, the prospects, I think for Direct Line as a business, you know, it does face some challenges. We had held it primarily as a yielding stock to generate to generate that income. But I think we have to now look at the at the underlying investment case, and see what happens whether there's an opportunity to crystallise some more value around that business or not.

And so, I think when something like that happens, it's more of a, it's more of a wait and see. I think the great trick most of the time is to try and avoid being in companies when they're cutting dividends because the business is suffering from major troubles. Think if it's a cyclical effort or a one off, perhaps a lot like some of the dividend cuts that we saw during COVID then I think, you know, one should be prepared to look through that. But I think if companies are cutting dividends because they can no longer sustainably generate cash flow, to pay those dividends or they're highly levered, then that's, you know, probably telling you something about the desirability of investing in that business. But it really does depend on your perspective. And I think where you're coming from on the investment case, I wouldn't say there's a hard and fast rule on these things, but I think generally speaking, much better not to be in stocks before they cut their dividends.

That said, you know, again, there's a certain breed of investor who would be considering stocks once they have cut their investors, has great value opportunity. So it's always a question of looking at the underlying fundamentals. But I think overall, as we look into this year, I'd say there was a, you know, a note of caution, the economic backdrop is more difficult. And you're not having that big rebound effect, which we saw coming through in ‘ 22. So I think it will be a bit more of a challenging year, but for underlying earnings, and underlying dividend growth, I think the markets saw just under 9% growth in ‘22. So we won't see that this year. But overall, I think we still feel the portfolio can make solid progress, and what will probably be a sort of fairly, a fairly choppy and challenging year ahead.

Cherry: Okay, thanks, Ben. And with that in mind, Rebecca, I mean, have you made any changes to the portfolio over the last couple of months?

Rebecca: There are two new holdings in the portfolio I'd like to talk through. So, the first is Sage, which is an accounting software business that operates in the UK and Europe and North America. The company has undergone a large amount of restructuring and reshaping of its portfolio divesting of lower quality, lower growth, assets and investing in its cloud capabilities, and some of its adjacencies in North America. And we feel that these changes mean that the company is in a really strong position to accelerate its top line, its revenue growth, and that this isn't appreciated by the market. So, the company has got a strong balance sheet, we do rate the management team. And it's got a high degree of recurring revenue, which if we are looking to a degree of concern around the outlook, and cyclic, some of the more cyclical sectors, then a company like Sage should perform relatively well given its high degree of visibility of its revenue base. So that's one that we've added, we see it as a solutions company. So, the company's accounting software enables small businesses to grow, to manage their time and manage their resources effectively. So that's how we how we think about the sustainability performance of the business.

And the second company is Hiscox. So, this is a speciality insurance company that operates both in the retail market in North America and in the reinsurance market. The company is benefiting from really strong pricing of premiums, which we think should drive earnings momentum in the business. And in addition, the company's digital capabilities in North America means that the company should continue to drive market share in that market. So, we think the company is in a really strong position. We think the company's got a strong capital position, and that valuation is attractive for a turnaround and to add for that capital position.

For an ESG perspective, we see Hiscox as an improver. So the company has got an important role to play in helping businesses protect themselves from the adverse impacts of climate change. And we're engaging with the company to understand how it's integrating climate change into its underwriting practices.

Cherry: Great, okay. Thank you, Rebecca. We'll wrap up there. Thank you, Ben, as well for those insights. And you can find out more about the trust at www.dunedinincomegrowth.co.uk. And thank you so much for tuning in.