DIGIT Digest

The outlook for DIGIT in 2022

January 2022

Ben Ritchie, Investment Manager, Dunedin Income Growth Investment Trust PLC

By most measures, 2021 was a remarkable year for UK equity investors. Economic growth, both domestic and global, hit record levels as countries bounced back from prolonged lockdowns. Investors also enjoyed the highest single-year earnings growth in modern financial history. On the back of this, companies continued to upgrade earnings forecasts throughout 2021. This combination of factors meant equity markets delivered strong returns, unusually favouring both value and growth type companies. While more defensive, lower volatility and higher yielding assets were somewhat out of favour.

But as we look to 2022, we believe companies and investors will have to navigate a more challenging landscape.

A more challenging outlook…

Annualised economic growth will slow as year-on-year comparisons become more challenging following a period of stellar expansion. At the same time, policymakers are gradually withdrawing the significant fiscal support enacted during the height of the pandemic. While from a monetary perspective the Federal Reserve will accelerate its tapering of bond buying and investor expectations for interest rate increases in the United States have been brought forward. Elsewhere, many emerging market central banks have been raising interest rates, while at home the Bank of England has become the first of the G7 economies to do the same.

Input costs have climbed dramatically. Supply chains have been put under huge pressure, making operations more difficult and resulting in inefficiencies, driving inflation and hampering growth in some sectors. Wage pressures have also become more visible  alongside extreme dislocations in energy markets. This has affected profitability in a number of sectors, notably industrials and consumer staples. Many businesses have indicated that these issues could persist well into 2022, with expectations for inflation to run above target into next year also gaining traction.

The slowing economy  in China, one of the key engines of global growth, adds to the additional headwinds that companies face. Its ‘Zero Covid-19’ policy has weighed on its economy as has the turmoil in its domestic property market and relatively tight fiscal and monetary policy. This is of particular relevance to the  UK market given its significant weighting to commodities.

On top of all this, concerns around Covid-19 have mounted, thanks to the emergence of the Omicron variant. While it’s too early to make a definitive judgement, this is likely to result in additional restrictions on daily life, serving to further mute economic activity.

…but there are reasons for optimism if you can deliver sustainable profits, cash flow and dividends…

Despite this long list of concerns, we believe most companies should be able to manage these factors. Many firms have already invested in strengthening their supply chains. Businesses have had to upgrade or revamp their operations during lockdown. A host of companies have emerged stronger as a result. This includes those that took market share from faltering rivals.

Nonetheless, we believe investors should continue to focus their attention and capital on businesses that can deliver sustainable earnings, cashflows and dividend growth. That means companies with strong competitive positions, pricing power and access to structural growth drivers. Those with the ability to return excess capital to investors should also find themselves in demand. While companies are expected to deliver c.50% earnings growth in 2021, 2022 is expected to bring much more “normal” returns with earnings growth in the low single digits and much more evenly spread by sector and style. Finding companies that can deliver against this will be key.

Investors have focussed on upside capture for much of the past two years. Against a more challenging backdrop, resilience of earnings, delivery of dividends, strong balance sheets and lower volatility of returns may also become more highly prized. Downside protection may once again come to the forefront of considerations as will managing ongoing environmental, social and governance risks.

That’s not to say the task ahead will be easy. The very real prospect of rising interest rates means investors need to ask questions about the valuation multiples they are paying. In general, companies that are more likely to deliver on earnings tend to come with richer valuations. Investors may therefore need to choose between earnings risk and valuation risk. Our view is that they will opt for the latter. In the current climate, many will be prepared to tolerate higher valuations in return for greater confidence that the company can deliver profits, cashflows and dividends. As a result we believe a strategy that focusses on great companies with upside opportunities but also downside protection makes a good deal of sense in current market conditions.

Where are we seeing opportunities?

The UK market has been out of favour for a number of years. We think this reflects a combination of significant exposure to sectors facing severe earnings challenges as well as the external perception of the impact of Brexit. However, it is important to remember that while the index may be concentrated in sectors with unfavourable economics, for those prepared to be active in their selection there are many other companies with much more attractive potential for the stock picker to consider. More than half of Dunedin’s portfolio is invested outside of the FTSE100 for example. It is also worth remembering that around 70 percent of the revenues of the UK market come from outside of the domestic economy, creating the potential to profit from global rather than local trends.

Areas such as healthcare, consumer goods and even financials offer plenty of opportunities for investors looking for compelling long-term prospects. Examples include Intermediate Capital Group, Coca Cola Hellenic Bottling and Dechra Pharmaceuticals. These businesses are largely driven by structural trends rather than cyclical ones. They should therefore prove more resilient even in more challenging operating environments and all three companies have taken advantage of the volatility of the past few years to emerge as stronger businesses, through a combination of acquisitions, organic expansion and strategic execution.

Looking closer, we believe Intermediate Capital is well placed as the investment market continues to shift to more private and alternative assets and its provision of products is positioned to take advantage. Coca Cola is able to access the rise of the middle classes in emerging markets, particularly in Eastern Europe and Africa, which remains a powerful structural support. Consumers’ ongoing switch to premium beverages such as energy drinks and coffee is also a positive for companies like Coca Cola. Meanwhile, Dechra benefits from increasing willingness from consumers to pay to look after their pets, increasing penetration of veterinary care and the opportunity to consolidate a fragmented market.

A sustainable approach will continue to be important

In 2022 environmental, social and governance considerations will continue to be key to investors. Indeed we expect the focus of investor attention on corporate behaviour to increase and the flow of capital towards companies that are seen as leaders in this area to accelerate.

Our highly integrated approach with ESG considerations embedded into each stage of our investment process leaves us extremely well placed to both avoid risks from companies with exposure to segments that we expect to come under significant economic pressure and to concentrate capital in businesses that we term “sustainable leaders”. Those poised to benefit from strong growth in areas such as electrification, decarbonisation and health and wellness provision.

Engagement to drive internal transformation in companies will also remain a critical aspect of our investment approach. For the year ahead we have a very active programme of interactions planned with the companies that we deem “improvers” within our portfolio to help enhance the way they do business and ultimately create additional shareholder value. Whether that comes from encouraging greater disclosure and reporting, enhancing governance to better align investors and managers or arguing for more substantive strategic changes.

Final thoughts…

From inflation to interest rates, to Covid-19 and slowing economic growth, 2022 will be challenging. However, we believe that the returns prospects will still be respectable for those who are prepared to be selective and back those companies with the ability to grow earnings, cash flows and dividends even amid a worsening backdrop. Sustainability, resilience and delivery will move further up the focus list for investors and Dunedin Income Growth should be well positioned to take advantage.

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 which is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered Office: 10 Queen’s Terrace, Aberdeen AB10 1XL. Registered in Scotland No. 108419. An investment trust should be considered only as part of a balanced portfolio. Under no circumstances should this information be considered as an offer or solicitation to deal in investments.

Find out more at www.dunedinincomegrowth.co.uk or by registering for updates. You can also follow us on Twitter and LinkedIn.

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Risk Warning
Risk warning
The value of investments and the income from them can go down as well as up and you may get back less than the amount invested. Please refer to the relevant Key Information Document (KID) prior to making an investment decision. Please be aware of scams that can affect investors.