DIGEST : topical themes from Dunedin Income Growth : The impact of the Ukraine crisis

Ben Ritchie, Samantha Brownlee and Rebecca Maclean, Investment Managers, Dunedin Income Growth Investment Trust

Three months into the Ukraine crisis and there remains little certainty on the longer-term outcome. While markets have recovered somewhat on slim hopes of a ceasefire, the military conflict and the horrific news stories continue. Investors continue to weigh up the longer-term consequences, but much remains unknowable.

For the UK economy, the war – and the resulting squeeze on commodity prices – is likely to accentuate many of the challenges that existed prior to the crisis. Inflation is likely to prove higher and more persistent than previously expected, given the high food and energy prices and supply chain difficulties. This will have an impact on demand and economic growth across Europe – and the UK is no exception.

The crisis also raises a number of challenges for both governments and central banks. Normalising monetary policy has become a little more difficult, though the Bank of England has held firm on rate rises. At the same time, the Government had been looking to rein in spending and shore up public finances, but higher inflation and its impact on the cost of living makes that more difficult.

This is an unpredictable moment and we need to fall back on what we know. We continue to focus on company analysis, finding those robust businesses able to withstand a challenging environment. That means looking at a company’s logistics and supply chains, its working capital, whether it has the ability to offset higher input prices and maintain margins. We also look at whether the company can sustain demand for its goods and services in different economic conditions. We like companies with structural demand in their markets, that have pricing power, with strong management teams and sustainable competitive advantages.

We were fairly cautious coming into the year, for different reasons. Our stance has been justified and we maintain it today.

The UK economy: over the worst?

The UK reported economic growth of 0.8% month on month for January, with the country’s economy finally returning to pre-pandemic levels. It was ahead of forecasts and generally welcomed by markets. The rise was driven by consumer spending, as people returned to pubs and restaurants after the Omicron surge over Christmas.

It is worth noting that the data does not take into account the impact of war in Ukraine, which will start to be felt in economic numbers from March onwards. Nevertheless, it is reassuring that the UK economy has some momentum coming into an environment that is going to be challenging. Higher energy and food prices, plus rises in National Insurance and various other costs will exert a drag on consumption as we move through the year.

Nevertheless, we've been making some selective additions to the portfolio, where valuations have assumed significant weakness in the UK economy that now doesn’t look likely to materialise. We've been adding to Persimmon, for example, which has underperformed significantly as a result of concerns over rising interest rates and the cladding scandal and have been able to maintain a generous dividend distribution. To our mind, to date it has remained a high margin business with a strong balance sheet.

Consumer discretionary in peril?

The consumer discretionary sector looks to be the most vulnerable to any weakness in the economic environment. However, it remains the second largest position in DIGIT at 13%. Our holdings within the sector are extremely selective, focused on those companies with stable demand and pricing power. Diageo, for example, is one of our biggest holdings. Historically, even where household budgets are strained, people still enjoy a drink. We also have exposure to Unilever. Its collection of brands could give it resilience even in the face of a tough consumer environment.

We also have exposure to some companies that wouldn’t necessarily be thought of as consumer companies. For example, GlaxoSmithKline – a top 20 holding in the portfolio - has a consumer health business that it is hoping to fly off in the summer. We also have exposure to companies that focus on animal health. While their income is linked to consumer spending, few pet owners think of spending on their furry friends as discretionary.

The problem of the oil sector

Energy stocks have seen strong performance since the start of the Ukraine crisis as commodity prices have soared. The trust has a sustainability overlay, which can make it difficult to invest in the sector. We need to see a specific level of commitment to renewables, a clear path to fossil fuel reduction and have limits on the level of revenues generated in specific areas. Equally, we exclude companies operating in shale or tar sands.

This naturally rules out a lot of the sector. Nevertheless, there are companies that make the grade. Total Energies, for example, has never had significant exposure to shale or tar sands. We're looking for businesses generating at least 40% of upstream revenues from natural gas and renewables and here too, Total Energies fits the bill. It has a large Liquefied Natural Gas (LNG) business, which is likely to be critical in terms of transitioning from fossil fuels to renewables over time.

There are also ‘softer’ considerations. Companies may meet the threshold, but we also need reassurance that the management team is committed to the move away from fossil fuels. There is a vital role for energy companies in the energy transition, but greenwashing is an issue. We need to be convinced that there is clear commitment for the task ahead.

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.
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  • 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.
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  • 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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