Dunedin Income Growth Investment Trust: manager update
An update from our co-managers, Louise Kernohan and Ben RitchieIn this podcast we are joined by Louise Kernohan and Ben Ritchie, co-managers of Dunedin Income Growth Investment Trust as they give their perspective on today's situation, highlight changes to the portfolio, discuss the hunt for income and explain how this investment company is preparing for the future.
Recorded on Tuesday 12th May 2020
Interviewer: Welcome to the latest in our Aberdeen Standard Investment Trusts podcast series where we catch up with our investment trust managers to look at how Covid-19 is impacting their portfolios. Today, we welcome Ben Ritchie and Louise Kernohan, co-managers of the Dunedin Income Growth Investment Trust (DIGIT). Welcome.
Can we start by looking at the stock market landscape today? There's obviously been a meaningful rally from the very lows seen last month, but which areas have proved particularly resilient and which still look vulnerable? Ben, I'll put that to you first.
Ben Ritchie: Thanks very much Cherry. I think when we look at it overall, it's really quite a complex picture and the environment is as challenging today as it has been probably at any point in my career when we look at what's going on in terms of evolution of markets. I think the important things to remember are that whenever something terrible happens for the economy, whether it's going back to the financial crisis or whether it’s the effect of the virus today, is the future is always uncertain and we don't know what's going to happen and we have to work on the basis of the information which we have available to us. I think when we look at the portfolio today, we feel very well positioned and we think we're in companies that have, generally speaking, got pretty good prospects even if the near term is tough. Where companies are facing more pressure on earnings, they’ve generally got very strong balance sheets, good cash flows or good cash balance sheets which are supporting their businesses through this tough time. And then we've also got a reasonable percentage of the portfolio which is continuing to trade, not completely without effect, but continuing to trade relatively robustly. When we put that all together, we have had less exposure to some of the areas that have been hit pretty hard. I think that that makes us feel that we're reasonably positioned going forward and the areas that have been hit hard, funnily enough have not been that surprising really. I mean, be it areas like travel and leisure, aerospace and defense, the banking sector, which I guess is always going to end up picking up some of the credit tab for the issues that we face, and then oil and gas which has been weak on the back of the challenges there. All in all we’re relatively light in all of those areas and we’re overweight to areas where the prospects look a little rosier, and we've been positioned like that for quite a while. I think when we put that all together, it's tough but we’re cautiously optimistic really about the prospects of the portfolio from here.
Interviewer: And Louise, would you add anything to that?
Louise Kernohan: Yes, just to add, as Ben says, it's a very complex landscape and we've seen quite a wide dispersion of performances between sectors. So you'll have some sectors that have performed very robustly throughout this period so far. So key examples there would be the pharmaceutical sector, which is being held up by being defensive - people still need their medicines. And it's actually those characteristics which are the reasons why it's attractive for us to invest in with DIGIT, and we indeed have an overweight position to healthcare, so that's been a positive. You've seen some sectors where they saw a really sharp decline in March, but then we've seen a subsequent sharp recovery and that is actually perhaps not unfair. For example, the construction and house building industry, we have Countryside Properties, which is an industry where there's a structural supply demand and balance and the government will be keen for that to resume as soon as safely possible and that is possible for those industries to resume in some way, shape, or form.
So there are positives on the horizon there. And then you've seen some industries which suffered badly throughout and haven't seen a recovery where there's just more longer term structural issues at play. So as Ben said, good examples are airlines, aerospace industry, and tour operators, where the outlook is just much more opaque at the moment and challenging. And also banks and oil, which has the structural challenges where again, it's because of these reasons to start with as to why we are underweight those industries. So it's been a tough period, but thankfully for DIGIT, we have been well positioned coming into it.
Interviewer: Okay, and Ben, individual sectors aside, do you think that the measures taken by governments and central banks have largely brought the systemic threats under control?
Ben Ritchie: I think there's a couple of pieces to this really, which is I think first of all, you've got to look at the financial plumbing and it was pretty clear in the first half of March that that was starting to creak and that you were seeing a failure of trust between counterparties within the financial system, be that investment banks, retail banks, hedge funds, asset managers, insurance companies. That whole circle was starting to stop. And when that does happen, we know that the impact of that is extremely bad. But the good thing I think about that element of it is that the central banks and policy makers have had relatively recent experience of how to manage that, both in the financial crisis, and in the Eurozone crisis and they have acted very-very quickly and very-very aggressively to provide effectively cash to actors within that area to support that. So I think that sort of systemic crisis caused by collapsing of natural system, which I think certainly looked like a possibility a couple of months ago, has been taken off the table. I think that's good news. I think the bigger challenge though if we think about it in a wider context is if this is a sort of Lehman Brothers and main street type situation, how the policy makers set about addressing those challenges because that's a lot more complex. You know, you're not just dealing with a couple of hundred financial institutions, you're dealing with literally millions and millions and millions of small businesses and millions of consumers. That's quite tough. So I think from the positive side, I think that the financial system is being insulated and I suspect that policy makers and central banks can make sure that that doesn’t recur through the deployment of their cash flows. I think the bigger challenges are now coming on to how do we manage unemployment, how do we keep the real economy alive during a period of time when activity levels are going to be very, very depressed and that is just perhaps a more complex and more challenging prospect for governments and policy makers globally, particularly I would say in Europe and the U.S.
Interviewer: Louise, I know it's very early days, but I wonder if any of the feedback that you're getting from companies gives any sort of insight or clues into those longer term prospects for companies?
Louise Kernohan: Yes, I mean, when it comes to speaking to the companies and talking about trading trends, the company management really don't know much or any better than any of the rest of us really. I think all of us are feeling our way through here and it can be interesting to hear comparisons to previous downturns, for example, the financial crisis, which can be interesting. So it might be the case that demand slumped for six months, but snapped back quickly before so there's reason to think that it might do it again, but really, because this downturn is so different, being more high street footfall related than being a financial crisis, those comparisons aren't always even going to be valid. So on the trading front, there's not really a huge amount that management can give us insight on. But what there has been a lot focus on, talking to management, has been the factors that they can control. So the primary focus there has first and foremost been on the safety of staff and companies are doing the best that they can to operate the best they can under the current conditions. So with staff either working at home or working on site with strict social distancing. Another focus is on cost, so many of the companies are using the furlough scheme – that scheme is seeing substantial take-up. We’ve seen dividend cuts, and conversations moving onto liquidity. For example, how long can a company operate at this low level of activity without coming into liquidity problems? We're finding that most companies are actually doing a really good job with this. Survivability isn't an issue for the vast, vast majority of companies, and really the question has sort of moved on to now to how can companies operate in a prolonged period of social distancing. And thinking about the fact that social distancing wasn't even a concept for any of us even a few months ago and now whole businesses are having to adapt to that. How do you adapt to a world where say, your demand might be half of what it was previously because of social distancing, but your cost base might not be that flexible. So that's the sort of thing that we're talking to companies about and there's just a wide variety of answers to that. Some companies are more straightforward, others are much more complex and so really sort of taking it on a case by case basis.
Interviewer: You have made some changes to the portfolio over this period, I believe, including raising gearing to reinvest in certain areas. I wonder if you could talk a little about the changes you've made Ben?
Ben Ritchie: Yes, so we acted as markets were performing pretty aggressively during mid-March to raise some additional debt to invest. It wasn’t a huge amount, four million pounds, but it was sort of indicative of the fact that we did see some reasonable opportunities developing to put money to work. And the kind of companies we were buying were businesses which we thought still have pretty solid dividend pending prospects, but where the valuations looked more attractive. Things like SSE, Coca-Cola Hellenic, a Coca-Cola bottling company, but primarily operating in Europe, and Rio Tinto - all businesses which we felt would be solid companies which were then trading perhaps 25% to 30% cheaper than they had done. The timing as ever on that wasn’t perfect as markets continued to go down a little bit more over the course of the rest of March. But we've added again to things like Coca-Cola and SSE a second time and in recent times we've actually been looking to add to some new things as well. So we've taken advantage of a very significant decline in the share price of Intermediate Capital Group, which is an alternative asset manager to be able to build a small position there. We've done the same with Hannover Rueck taking advantage of our overseas capability to buy what we think is one of the world's best reinsurance companies at a pretty reasonable price at a time when the reinsurance markets look like they are poised for growth. We've also bought a stake effectively in the Chinese company Tencent through a Dutch listed company called Prosus, which owns a very large stake in Tencent and trades at a big discount to the value of its assets. So we've been quite active in terms of looking to add things to the portfolio during this period of time. Especially by our standards - we tend to take a fairly long term view, but there have been a few opportunities that are being thrown up by events.
Interviewer: Okay, Louise, how are you making the distinction between companies that are in temporary trouble and those where the outlook has fundamentally changed? Have you exited any positions on that basis?
Louise Kernohan: So that is really the key question for any investor right now - making that distinction between companies where this is a transient problem and where actually this is a longer term issue which fundamentally changes the value of the business. So ever since the start of this crisis, Ben and I have been fully focusing on that and thinking about the businesses. Not just about which ones will survive, I mean that is obviously key, but it's not just that, it’s about also which ones will not only survive, but which will come out in a stronger position. While none of us can predict the future, you can choose winning businesses within an industry that have structural advantages, good financial firepower, which leaves the business in the best possible position. So I mean, an example here would be Rightmove where clearly the UK housing market isn't moving at the moment. Rightmove’s customers, being the estate agents, are in an extremely challenging place, which is naturally going to affect Rightmove and it's easy to paint a bad near term scenario for them because their competitors are offering free services to their customers trying to steal what little business there is out there. But what’s important for Rightmove in terms of thinking about has the outlook fundamentally changed longer term? Well, the reality is that Rightmove’s network remains far, far superior to any of its peers. So, they can try and charge cheaper, but at the end of the day Rightmove’s customers want the website that has the most property on, and the most viewers and they’re head and shoulders above the rest. Very little can threaten that and they have a very strong balance sheet which allows them to not just be able to survive, but to be able to invest in their business and proposition through this period where competitors can't, and so that they come out stronger again. And you know, I don't think any of us are in any doubt that the housing market will start moving again at some point in the future. I don’t know how much or how soon, but people will still need to move houses. So, that's kind of how we've been thinking about focusing on the long term in that respect.
Interviewer: Okay. I wonder if we could also look at the income side. Louise, a lot of companies have been cutting dividends, and while I recognise the type of companies in which you invest may be more insulated from that, how are you managing that in the portfolio? Are you having to take the decision on, where a company has cut, whether you hold or whether you sell out?
Louise Kernohan: I think it's fair to say that this level of dividend cuts hasn't been in anybody's scenario planning. So I think the last time that I checked there were 41 companies in the FTSE-100 that have cut or suspended, and 96 in the FTSE-250. So this is - you know, unprecedented I think is an overused word at the moment, but I mean, it's the right word. So yes, it goes without saying that this is not an easy scenario. A positive for our situation is that our focus on high quality businesses, with, as we’ve spoken about, strong business models, resilient earnings, strong cash flows, strong balance sheets, has led us to start this in a strong position and we estimate that the level of income cuts for us is around 15% to 20%, which would be, I mean, it's moving around quite a lot, but it's less than half of the broader market. So, by not owning the UK banks, by only having minimal exposure to oil has been really helpful during this period. We also entered the year with almost a year's worth of dividend in reserve. So, we're in a strong position on that front. We've always generated some additional income, up to 10% from option writing and that will be helpful this year too. Also to remember that given our strategy that we've been implementing for the past few years of actively choosing to sell higher yielding companies such as the oil majors, which have high yields but low growth prospects, to reinvest in lower yielding companies with higher growth prospects - as part of that process we were planning to run with an uncovered dividend this year anyway. So, whilst the situation isn’t one of anybody's choosing, we started it in a very strong position, so sitting here today we're feeling that we're in a strong position. In terms of what we're not going to do - we're not going to start chasing yield. So, we're not knee jerk selling out of companies that have cut the dividend if we still believe in the long term prospects of that business, and we're not investing in companies that are still paying the dividend at the detriment to investing in the high quality standards that we always do.
Interviewer: Okay. Looking a bit longer term then, it seems clear that the economic growth will be harder to come by as we recover from the virus. You mentioned healthcare earlier, do you think it will be a case of finding pockets of structural growth?
Ben Ritchie: Yes, it's quite interesting actually, Louise and I were chatting the other day, and looking through the portfolio and we actually have more opportunities to deploy money than we have things that we want to sell at the moment. So, I think it’s a good, good position to be in. And we skipped through the portfolio and there wasn't really anything we wanted to sell which is always helpful. You need something to sell to be able to buy, but I think that focusing in on those opportunities is a positive for us at the moment and I think that's absolutely the case. I mean, healthcare is an obvious one in some ways, and we’re operating in an environment where a) that's a relatively stable business and b), there's likely to be more investment in it going forward, but actually when you look at our healthcare exposure, it is more sophisticated than just owning the big pharmaceutical companies. Louise in her other role as the pharmaceutical analyst on the UK team has made a great call on being very enthusiastic about Astra(Zeneca) and Glaxo(SmithKline) for much, much longer than the last few months. Over the last couple of years they've been really good investments for this particular portfolio, but we've also been able to benefit from exposure to companies like Genus, which helps with the production of food through its expertise in production of the sort of reproducing, reproduction capabilities for pigs and for cows. Things like Dechra, which again, is a veterinary science business. Something like Abcam, which is all about antibody production, owning things like Novo Nordisk, again taking advantage of our ability to invest overseas. So we do have that big healthcare exposure, but it's not just big pharma, it's also little businesses as well. And when we look across the picture, we see some interesting opportunities in a number of different end markets to be able to grow. But I think the point is, is that you do have to be very selective. You do have to be niche, but actually there are those potential opportunities out there and I think we are looking at a world going forward from this, and it may be a bit different with a sort of three to five year view, but I'm pretty sure in the near term the environment is going to look a lot like the environment which we've been in. Which is low growth, low inflation, low interest rates. And that is going to create an environment, which as you eluded to earlier, where growth is probably going to be at even more of a premium than it was before. And I think when we look across the portfolio we see good opportunities in a range of areas and also quite a diverse range of different earnings drivers as well, from insurance to clothes, life books through to emerging market asset managers through to branded consumer goods and on to specialty chemicals. You know, we see lots of little areas, but there probably isn’t a big unifying theme behind all of that. It's just lots of little, lots of little areas which we're looking to try and take advantage of, and it's that combination of lots of stock picks all put together that ultimately builds quite an attractive portfolio overall.
Interviewer: Okay. Louise how comfortable are you with valuations in today's market? Do you think they fully reflect the problems out there?
Louise Kernohan: Well, the problem with valuations at the moment is that all the multiples require some estimate of earnings or cash flow. And so that number in the equation is obviously extremely uncertain at the moment. So that means that valuations are uncertain. So if we see a good recovery from here, so what people call the V-shape, then valuations are attractive right now. But on the contrary, if we're standing at the start of deep recession, then on the whole valuations will be expensive, and particularly considering the recent recovery. I think it's also fair to say that we entered at the start of this year with valuations on the whole not being particularly cheap. It's actually quite difficult to summarize on the whole, but I think what is fair to say is that given how volatile markets have been and still are, the markets clearly have a lot of inefficiencies at the moment. So there's a lot of opportunities. So the key is really to look on a stock by stock basis and try to find those companies that have been hit due to concerns, but in fact actually those concerns aren't valid. We have seen that already so far, for example companies like Coca-Cola Hellenic, the soft drink company. It's share price was hit along with some of the worst during March. But at the end of the day, it's a soft drink bottler across a range of geographies, and so whilst not immune because not many companies are, it should prove relatively resilient through this and so we topped it up and we have seen some recovery. And there's lots of examples where there are mis-pricings so that's really what we're trying to find. And as Ben said, there's a lot of opportunity at the moment. Where we really benefit as well is that Ben and I both work on large equity teams. So, we've got a 16 strong UK equity team with full coverage of the FTSE-350, doing a lot of individual analysis of companies, talking to management, doing lots of in depth work. And we’ve got the same size European team, doing the same for European stocks of which we hold a number in the trust. So, we have a really good position in terms of having a lot of resource focused on this and I'm sure there's going to be a lot more opportunities that arise through this situation for valuations.
Interviewer: Okay, and just finally, what reassurance would you give to investors in the Trust that they should hold on through this period of rather nasty volatility?
Ben Ritchie: Yes, a very good question to ask, that one. I think, as Louise said earlier, from an income perspective, we feel in good shape. Though you know, we’ve taken a very, very hefty hit, but it's been a lot less than the wider market. So we think from an income perspective that we're still, given our reserves and potentially the ability to distribute income from capital, from an income perspective we think we're in good shape. From a capital perspective, we don't see any companies in the portfolio that are showing any signs of distress at all and we actually think if anything, there’s a very, very significant percentage of the portfolio which is actually in a pretty good place and provided things recover to some degree, will actually do pretty well. And some of those companies may even do a lot better than that over the longer term. And I think that the point that Louise was making earlier, we both run unconstrained money as one of our key elements and so everything we're asking ourselves about every investment we make is do we think that this is a really attractive total return investment opportunity? That's the first point, and then we look at how much of that return is going to come from income and then we look at what the income requirements of the Trust are. I think that gives us a very different perspective. It's almost like looking down the pipe the other way from a lot of income managers - we start with well, what’s the yield and what's the dividend going to grow at, because ultimately at the end of the day the dividend is just the output of the business and we like to start with the business. I think that's a key thing as opposed to starting from the dividend end of things. If you do that, then generally speaking you're going to end up with a portfolio of really, really good businesses and that's ultimately what makes myself and Louise feel positive is the fact that we've got some really great businesses in the portfolio and their prospects are looking good. At the end of the day, I think as Louise was mentioning earlier, we think that the companies are being managed well and we are ultimately delegating control and management of the businesses to the management teams. You know, by and large we think they've been doing a pretty good job throughout this crisis and meeting the challenges well. And while we don't know how things are going to evolve, assuming, I think it’s fair to assume that over the coming months and perhaps years we will see a recovery of maybe slow but a steady recovery out of this, this trough, then you know, we think we're well placed to go well from here. You know, the performance over the last sort of three or four years since we've taken the helm of the Trust has been good. And if anything, this environment we think sort of suits our style and approach.
Interviewer: Great. Okay. Thank you so much Ben and Louise for those insights today. Thank you also to our listeners for tuning in. You can find out more about the trust at www.dunedinincomegrowth.co.uk and do look out for future episodes.
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