Fund Manager's Report

Market review

The UK equity market produced positive returns during the year, with the FTSE All-Share Index up by 7.9% on a total return basis. Falling inflation and a pause in interest rate hikes by central banks, especially the US, UK and Europe, were the main driving forces for equity returns in 2023. Inflation in the UK (as measured by CPI), which started the year at 9.2%, fell to 4.2% by December, benefitting from lower energy prices, the loosening of supply chains and fading food price inflation. The Bank of England increased interest rates five times in the year to reach 5.25% by August, before pausing. The UK economy weakened during the year and slipped into a technical recession in the fourth quarter, albeit GDP growth was only modestly negative.

The UK market performance was fairly broad based with the mid-cap FTSE 250 (+8.0%) marginally outperforming the larger-cap FTSE 100 (+7.9%). However, the vast majority of performance from medium sized companies came in the fourth quarter as markets reacted positively to inflation falling more than expected in October. Despite the recent rebound in that area of the market, it has still significantly underperformed mega cap companies (the largest 20 companies in the UK) over the past two years. Cyclical sectors performed best over the year with financials, industrials and consumer discretionary outperforming, while defensive sectors such as health care, consumer staples and telecommunications lagged. Despite the fall in the oil price during the year, due to concerns over Chinese demand given its weakening economy, the oil & gas sector outperformed. The mining sector underperformed in contrast, despite iron ore and copper prices rising, as production issues and cost inflation weighed on sector profits.

Bonds were volatile during the year with yields initially rising in the first half of the year to reflect stubbornly high inflation and increased interest rates. The UK 10-year gilt yield rose from 3.7% at the start of the year to reach a peak of 4.7% in August. Despite the hawkish narrative from central bankers globally, bond yields fell dramatically in the fourth quarter as the market started to price in rate cuts in early 2024 given that inflation began to decline below expectations, particularly in North America. The 10-year gilt yield finished the year at 3.5%, albeit it has since risen as markets have had to reassess their estimates of when the first rate cut may come. Both government and corporate bonds produced positive returns for the year after negative returns in the previous two years.

Performance review

The Company's NAV (debt at fair value) returned 9.8% on a total return basis, outperforming the benchmark's gain of 8.1%. Good stock selection within the equity portfolio drove the outperformance, while gearing also contributed positively.

The equity portfolio gained 10.4% on a total return basis during the year, outperforming the FTSE All-Share Index return of 7.9%. The portfolio's holdings in financials 3i and Intermediate Capital were positive for performance. Private equity group 3i benefitted from its portfolio holding in Action, the European discount retailer, which delivered strong profit growth underpinned by its value proposition and its store roll out strategy. Despite a more difficult macro environment, alternative asset manager Intermediate Capital continued to attract inflows with the company delivering its 4-year fundraising target a year ahead of expectations.

The portfolio's positions in other consumer stocks that offer value to customers also performed well. B&M European Value Retail saw good growth in volumes benefitting from more cost-conscious consumers given the "cost of living" crisis. Tesco also outperformed with the company's drive to become the cheapest full line grocer producing market share gains, good profit growth and attractive cash flow.  Elsewhere, holdings in Hilton Food Group and RELX also aided performance. Hilton Food Group reported resilient trading in its core meat division, while management action to improve its troubled seafood business showed progress with the business back in profit by the end of the year. RELX announced strong organic growth ahead of its historic average, benefitting from its continued investment in technology tools and analytics.

On the negative side the portfolio's holdings in British American Tobacco, Anglo American and NatWest detracted from returns. British American Tobacco announced a payout of $635 million to resolve investigations by the US Department of Justice into the company's historical business activities in North Korea. It also disappointed the market with weaker trading, the suspension of the share buyback and a non-cash impairment charge of £25 billion relating to the Reynolds acquisition in 2017. Anglo American shares were impacted by falling PGM (Platinum Group Metals) prices, while the announced reduction in production guidance towards the end of the year also disappointed investors. Despite higher interest rates, NatWest reported weaker margins given increased competition in savings and mortgage products.

The fixed income portfolio rose 4.6% on a total return basis during the year, but this lagged the 8.6% return from the ICE BofA Sterling Non-Gilts Index. The portfolio's exposure to short duration government bonds was detrimental to relative performance given the underperformance of gilts relative to UK corporate bonds. The weakness in the US dollar also created a headwind to relative performance for the US bond holdings. Holdings in high yield bonds, such as Direct Line, Bupa, CenterParcs and Virgin Media, were positive for performance given the more resilient UK economy saw credit spreads tighten during the year.

Income review

On a headline basis UK market dividends fell 3.7% (according to the Computershare UK Dividend Monitor), however, this was driven by a decline in special dividends versus 2022, and the strength of sterling during the year given the number of large companies that declare their dividends in dollars. On an underlying dividend basis (ex special dividends), aggregate UK market dividends grew 5.4% at constant currency. This was primarily due to good growth in dividends from banks and oil & gas companies.

The income return for the Company in 2023 marginally increased to 10.39p per share, from 10.37p in 2022.  Despite income from underlying dividends in the equity portfolio growing 6.8% in the year, there were a number of headwinds which offset this. Special dividends were significantly down from the prior year with only £241,000 earned by the Company versus £1.1 million in 2022.  Given the rise in interest rates during the period, the Company's interest costs charged to income from its revolving credit facility also increased, although income from the bond portfolio also rose given the higher yields available which helped dampen this impact.

During the year the Board declared a full year dividend of 10.35p which was fully covered by earnings with £128,000 being added to revenue reserves. This was an increase of 2.0% over the dividend in 2022 (10.15p) and represents the eleventh consecutive year of dividend growth, maintaining the Company's status as an AIC Next Generation Dividend Hero. The dividend has grown at a compound annual growth rate of 2.0% over those 11 years. Revenue reserves as at 31 December 2023 were £8.9 million.

Portfolio Activity

As at the end of the year gearing was 21.4%, in line with the level as at the end of 2022. A net £4.4 million was added to the bond portfolio taking advantage of the move higher in yields. New positions were initiated in both investment grade and high yield bonds but in typically higher quality, non-cyclical businesses such as Électricité de France (EDF) (European utility), Allwyn Entertainment (European lottery operator) and Banijay Entertainment (TV content creator). In the middle of the year, some of the lowest yielding investment grade bonds in the portfolio were sold, where credit spreads were particularly tight, and reinvested in short dated government bonds, both a UK gilt and a US treasury bond. The bond portfolio represented 12.3% and 14.9% of gross and net assets respectively as at the end of December. 

New positions initiated in the equity portfolio included DCC, Conduit Re and Engie. DCC is an international sales, marketing and distribution company operating in the LPG, oil, technology and health care sectors. It is a resilient business with strong free cash flow, high returns and a robust balance sheet which should support further accretive bolt on acquisitions. Engie is a French integrated utility and is a diversified business involved in the generation, distribution and supply of energy in Europe and Latin America. The company has a credible business plan with the build out of its renewable energy project pipeline likely to lead to good earnings growth. Conduit Re is a specialist property and casualty reinsurer with a diversified portfolio of reinsurance risks. Given the capacity that has come out of the reinsurance market after a number of years of large losses, the market is entering a period of strong premium rate rises which should underpin high returns over the medium term. The valuation is attractive with the company trading at a discount to its net asset value.

In the second half of the year we started to position the equity portfolio for a cyclical recovery, taking advantage of attractive valuations in more domestic and cyclical businesses on the assumption that interest rates were near peak levels for this cycle. New holdings were initiated in Genuit, Taylor Wimpey and British Land.

Genuit is the UK's leading provider of plastic piping systems for residential, commercial and infrastructure sectors. The company is exposed to a number of structural tailwinds enforced by government regulation while new management are restructuring the business to drive cost efficiencies and higher margins over the longer term. Although the outlook for the UK housing market is uncertain, we believed this was already discounted with Taylor Wimpey's share trading at a discount to its book value. The company has a very strong balance sheet and with mortgage rates starting to fall, transaction volumes should start to recover. British Land is a diversified UK commercial real estate company with exposure to London office campuses and wider UK retail exposure. After a number of years of falling prices, we believe that property values have now troughed, especially in retail, while the company is also experiencing a return of rental growth. The valuation is attractive with the shares trading at a significant discount to its net asset value.

During the year there was a general trend to lower the Company's exposure to overseas stocks, recognising the relative attractiveness of valuations in the UK market. Holdings in McDonalds and Deutsche Post were sold after a period of outperformance and where we believed the valuations had reached a full level. Also the position in Scandinavian bank Nordea was exited given the fears we had over the health of economies in the region and its exposure to commercial real estate.

Elsewhere the holdings in Sage Group, United Utilities and Vistry were also sold. Accounting software company Sage Group had performed well, with the valuation fully discounting a continuation of the company's strong organic growth, which could come under pressure from a slowing macro-economic environment. We believe the next regulatory review period could be difficult for United Utilities given the significant investment needed in waste water infrastructure at a time when there is increased scrutiny on consumer bills, debt levels and dividend payments by the sector, especially with a general election likely this year, which could weigh on the share price. The Company sold its holding in housebuilder Vistry after a change in strategy and capital allocation policy. While we agreed with the change in strategy to focus solely on its Partnership division, which builds affordable housing on a contracted basis, we disagreed with the company's decision to suspend the dividend in favour of buying back shares. 

Outlook

Over the past two years, global market returns, both equity and bonds, have been shaped by inflation and the sharp rise in interest rates. Now that inflation is falling, the pressure on central banks to keep monetary policy tight is easing which suggests rates could be cut over the next 12 months. While the impact of the significant rise in interest rates on economic growth needs to be carefully watched, consumer borrowings are historically low, corporate balance sheets are robust and the banking sector is well capitalised. With wage growth also likely to outstrip inflation this year, the outlook for the UK economy could be better than current low expectations, albeit still below trend.

Similar to the UK, global economic growth is likely to be better this year than expectations a year ago, given that the US economy has proved more resilient. Offsetting this has been China, where economic growth has disappointed despite the government introducing stimulus measures. The US economy should avoid recession this year given manufacturing lead indicators are now recovering and unemployment, albeit rising, is still at low levels. 

While a more subdued economic environment, along with higher interest rates and higher costs, is likely to be a headwind for earnings growth, equity valuations in the UK are attractive both versus their own history and relative to global equity markets and we have continued to see overseas buyers make approaches to quoted UK companies. Although one has to be mindful of geopolitical risks, we remain cautiously optimistic that equities can make positive progress over the medium term. As ever the focus remains on finding good quality businesses at a compelling valuation that can pay and grow an attractive dividend.

David Smith

Fund Manager

27 March 2024

NOTES TO THE FINANCIAL STATEMENTS

1a. Accounting policies: basis of accounting

The Company is an investment company as defined in Section 833 of the Companies Act 2006 and is incorporated in the UK. It operates in England and Wales and is registered at 201 Bishopsgate, London EC2M 3AE. The financial statements have been prepared in accordance with the Companies Act 2006, FRS 102 - The Financial Reporting Standard applicable in the UK and Republic of Ireland, and with the AIC Statement of Recommended Practice: Financial Statements of Investment Trust Companies and Venture Capital Trusts (SORP).

The principal accounting policies applied in the presentation of these financial statements are set out below. These policies have been consistently applied to all the years presented.

The financial statements have been prepared under the historical cost basis except for the measurement at fair value of investments.

In applying FRS 102, financial instruments have been accounted for in accordance with Sections 11 and 12 of the standard. All of the Company's operations are of a continuing nature.

1b. Significant judgments and estimates

The decision to allocate special dividends as income or capital is a judgment but not deemed to be material. The allocation of expenses as income or capital is not material but has an impact on distributable reserves. The Directors do not consider these to be significant judgments or estimates and do not believe that any accounting judgments or estimates have been applied to this set of financial statements that have a significant risk of causing a material adjustment to the carrying amount of assets and liabilities within the next financial year.

1c. Going concern

The assets of the Company consist of securities that are readily realisable and, accordingly, the Directors believe that the Company has adequate resources to continue in operational existence for at least twelve months from the date of approval of the financial statements.

The Company's shareholders are asked every five years to vote for the continuation of the Company. An ordinary resolution to this effect was passed by the shareholders at the annual general meeting held on 23 June 2020.

The Directors have considered the risks associated with rising interest rates and its impact on the broader financial system, as well as the risks arising from the wider ramifications of geopolitical conflicts, including cash flow forecasting, a review of covenant compliance including the headroom above the most restrictive covenants and an assessment of the liquidity of the portfolio. They have concluded that they are able to meet their financial obligations, including the repayment of the bank loan, as they fall due for a period of at least twelve months from the date of issuance. Having assessed these factors, the principal risks and other matters discussed in connection with the viability statement, the Board has determined that it is appropriate for the financial statements to be prepared on a going concern basis.

2. Gains/(losses) on Investments Held at Fair Value through Profit or Loss

Management fees are charged in accordance with the terms of the management agreement which are set out in the Company's Annual Report for the year-ended 31 December 2023.

A summary of the terms of the Investment Management Agreement is given in the Annual Report. An explanation of the split between revenue and capital is contained in Note 1g to the financial statements in the Annual Report.

6.  Profit/(loss) for the year

Profit/(loss) attributable per ordinary share figure is based on the return attributable to the ordinary shares of £21,420,000 (2022 loss: £11,022,000) and on the 129,796,278 weighted average number of ordinary shares in issue during the year (2022: 129,401,141).

The Company had no securities in issue that could dilute the return per ordinary share. The return per ordinary share can be analysed between revenue and capital as shown below:

During the year the Company issued nil shares (2022: 1,200,000 shares) for net proceeds of £nil (2022: £2,104,000).

On 16 January 2024 the Company issued 42,345,422 new shares to Henderson Diversified Income Trust plc (HDIV) shareholders in consideration of the £72.1 million of net assets acquired from HDIV in accordance with the scheme of reconstruction and winding up of HDIV under section 110 of the Insolvency Act 1986. Between 18 January and 27 March 2024, no further shares have been issued. Accordingly, the number of shares in issue with voting rights as at 27 March 2024 was 172,141,700. 

8.   Net Asset Value Per Ordinary Share (Basic and Diluted)

The net asset value per ordinary share is based on the net assets attributable to the ordinary shares of £222,342,000 (2022: £214,277,000) and on the 129,796,278 ordinary shares in issue at 31 December 2023 (2022: 129,796,278).

The movements during the year of the assets attributable to the ordinary shares were as follows: