Fund Manager's Report

Market review

The UK equity market made positive gains during the year, with the FTSE All-Share Index increasing by 9.5% on a total return basis. Easing inflation prompted major central banks, including the Bank of England (BoE), to reduce interest rates globally. The BoE cut UK interest rates by 25 basis points in both August and November to end the year at 4.75%.

The equity market gains were skewed to the first half of the year as UK economic growth generally proved better than expected. However, the negative rhetoric over the state of the country's finances the new Labour government had inherited, post July's General Election, saw markets consolidate in the second half of the year. Domestic companies were also impacted by the large tax increases announced by the new Chancellor in her first Budget. Businesses will be expected to fund a significant portion of the bill given the rise in employer National Insurance contributions, although the government also unveiled plans for a large rise in investment spending. Consumer and business confidence fell towards the end of the year while UK economic growth weakened with almost no growth in the second half of the year.

Larger companies outperformed medium sized businesses with the FTSE 100 Index returning +9.7% versus the more domestic orientated FTSE 250 Index's return of +8.1%. The best performing sectors were financials (led by banks), consumer staples and industrials, while energy, basic materials and real estate underperformed. While the consumer discretionary sector outperformed there was a large dispersion of performances, with travel and media companies performing well but the more interest rate sensitive sectors, such as retail and housebuilders, underperforming. 

Government bonds were weak during the year as initially investors pared back their expectations over interest rate cuts as inflation, albeit falling, generally remained above central bank targets. Bond yields rose significantly in the fourth quarter globally, led by the US given fears over inflation from some of president-elect Donald Trump's proposed policies. The move in the UK was further exacerbated by the scale of government spending revealed in the Budget, along with concerns over the impact on inflation from tax hikes, increases to the minimum wage and further falls in productivity. The UK 10-year gilt yield rose from 3.6% at the start of the year to reach 4.6% at the end of December. Credit spreads tightened during the year which helped corporate bonds, both investment grade and high yield bonds, post positive returns and outperform government bonds.

Performance review

The Company's NAV (debt at fair value) returned 9.4% on a total return basis, outperforming the benchmark's gain of 7.9%. Given the Company's overweight position to equities relative to bonds against the benchmark, asset allocation had a positive impact on performance due to equities outperforming. Gearing also aided performance given the positive market backdrop.

The equity portfolio gained 8.7% on a total return basis during the year, behind the 9.5% return from the FTSE All-Share Index. Within financials, the portfolio's holdings in NatWest, 3i and Intermediate Capital were positive for performance. NatWest delivered strong profit growth in the period benefitting from higher interest rates in the UK and stronger margins given the benign competitive environment, especially within savings and mortgage products. The company's robust capital position and strong cash flow also led to good dividend growth and a directed buyback which significantly reduced the government stake. Private equity group 3i has been a very strong performer for the Company over the longer term, driven by the success of its portfolio holding Action, the European discount retailer. Last year was another good year for the business given the strong profit growth delivered. Alternative asset manager Intermediate Capital, which specialises in private credit markets, performed well over the year as new fund raisings for its strategies beat expectations.

Within the consumer staples sector, the portfolio's positions in tobacco companies, Imperial Brands and British American Tobacco, and soft drink manufacturer Britvic were positive for performance.  Both Imperial Brands and British American Tobacco benefitted in the period from delivering resilient earnings but also buying back their own shares at very attractive valuations. Britvic produced strong results in the period and then was subject to a bid approach from Carlsberg, as it looked to diversify away from beer and consolidate its European Pepsi bottling operations.

On the negative side the portfolio's holdings in Burberry, PageGroup and MONY Group (owner of MoneySuperMarket.com) detracted from returns. Burberry's profits were significantly impacted from a slowdown in luxury goods demand and a failed strategy to elevate the brand. While it was the correct decision for the company to change strategy and Chief Executive Officer, the turnaround is likely to be protracted and with the suspension of the dividend we decided to exit the holding. Recruiter PageGroup was weak during the year as profits came under pressure from a lacklustre global employment market with low candidate confidence impacting job turnover. MONY Group's share price was weak as investors feared that an easing in insurance premium price inflation would lead to fewer consumers switching their insurance providers. Elsewhere, not holding Rolls-Royce was detrimental to relative performance. Rolls-Royce is a large constituent of the benchmark and performed strongly in 2024 meaning not holding the company, due to the lack of a dividend, contributed negatively to relative performance against the benchmark.

The fixed income portfolio rose 6.7% on a total return basis during the year, outperforming the 1.7% return from the ICE BofA Sterling Non-Gilts Index. The portfolio's exposure to short duration bonds aided relative performance given these bonds are typically less vulnerable to rising bond yields. Also, the holdings in high yield bonds aided returns given spreads in this area of the bond market tightened significantly as global economic growth improved. In particular, holdings in bonds issued by Bupa, Center Parcs, the Co-op and Ziggo were positive, while bonds in Direct Line rose significantly after the bid approach from Aviva.

Income review

On an underlying basis, UK market dividends fell 0.4% in 2024 (according to the Computershare UK Dividend Monitor) driven by reductions in dividends from the mining sector as commodity prices fell during the year. Dividend growth excluding this sector was 4.0%, supported by good dividend increases from banks, insurers and food retailers. 

The income return for the Company increased 3.4% to 10.74 pence per share in 2024, up from 10.39 pence in 2023. Within the equity portfolio there was good dividend growth from some of the largest holdings including 3i (+15.6%), HSBC (+15.1%), Tesco (+14.7%) and NatWest (+12.9%). Along with the miners, the portfolio experienced dividend cuts from holdings in the utilities sector: National Grid rebased its dividend lower as part of its equity raise to fund future investment, while SSE also reduced its dividend during the year to support higher capital investment, albeit this had been well flagged to the market. 

There has been a trend over the last couple of years for UK companies to return excess cash to shareholders via share buybacks, a recognition by management teams of the attractive valuations of their companies' shares. This has generally come at the expense of special dividends, hence, income earned from specials for the Company was relatively low versus previous years. The portfolio in total earned £347,000 in special dividends with payments from Dunelm, B&M and Sabre. 

During the year the Board declared a full year dividend of 10.6p which was fully covered by earnings. This was an increase of 2.4% over the dividend in 2023 (10.35p) and represents the 12^th 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 2.1% over those 12 years. Revenue reserves as at 31 December 2024 were £10.2 million, providing approximately 56% cover over the Company's dividend.

Portfolio activity

At the start of the year the Company completed the proposed combination with Henderson Diversified Income Trust plc (HDIV). The £72.1 million of new assets taken on as part of the transaction were invested in line with the existing portfolio. 

Gearing at the end of December was 21.0%, down slightly from the end of 2023 (21.4%). The bond portfolio was reduced by approximately £2 million through the year. Although all-in-yields remain attractive, credit spreads have tightened to historically low levels. New positions were initiated in both investment grade and high yield bonds but in typically higher quality, non-cyclical businesses such as Iliad (European telecommunications), Aviva and Teva Pharmaceuticals. Funding came from the sale of the short-dated US Treasury bond the Company held ahead of its maturity. Holdings in bonds issued by EDF (French utility) and Centene (US healthcare) were also sold. The bond portfolio represented 10.7% and 13.1% of gross and net assets respectively as at the end of December. 

New positions were initiated in the portfolio in Reckitt Benckiser, Aviva and Tele2. Reckitt Benckiser is a global household goods and personal care business which has market leading brands in attractive categories. The new strategy to divest lower growth businesses to become more focused on its core faster growing products is sensible. Also, while there continues to be uncertainties around litigation in its instant milk formula division, we believe these are more than discounted in the current valuation. After a period of restructuring, Aviva is now a much simpler business with good market positions in its core operations in the UK and Canada. It is well diversified across both life and general insurance and generates good cash flow. Tele2 is the no.2 telecommunications operator in Sweden, with mobile and fixed networks, and is the market leading mobile operator in the Baltic countries. These regions should be able to generate stable growth, while continued cost savings and peaking capex is likely to lead to stronger cash generation which supports an attractive dividend yield.

Within the aerospace and defence sector, new positions were established in BAE Systems and Chemring towards the end of the year. Although there is a potential for a ceasefire in Ukraine, given rising geopolitical tensions governments across the world are likely to increase defence spending over the longer term, which should underpin future profit growth for the sector. BAE is well-diversified both globally and across product platforms. The valuation is attractive given the strong organic growth potential, high visibility on earnings given the size of the order backlog, and good cash flow generation. Chemring has strong market positions in specialised niche areas of defence. The company is split into two divisions: Countermeasures and Energetics, which manufactures products such as explosive materials and missile parts, and Sensors and Information, which develops technologies that detect threats whether explosive, biological, chemical, radio or cyber. 

Within the retail sector we switched our holding in B&M European Value Retail into Dunelm at the beginning of the year. This was due to concerns that B&M was being run too aggressively to maintain its low pricing in a competitive space. Dunelm is the UK's leading homewares retailer in a fragmented market where it continues to invest to improve efficiencies and product offering. The broadening out of its product range into new categories and price points, while still offering value for money to customers, should drive further profitable growth. The company also has a robust balance sheet and high free cash flow that supports attractive dividends.

Elsewhere the holdings in overseas companies Woodside Energy and E.ON were also sold. With the Liquefied Natural Gas (LNG) market likely to be in surplus over the next couple of years as new supply comes on stream, we took the decision to exit our holding in Woodside given 50% of the business is exposed to LNG. Also, the management team has significantly increased the capex guidance and recently bid for peer Santos. Although the proposed acquisition was ultimately dropped it highlighted that cash returns to shareholders were likely to be less of a priority going forward. E.ON had performed well last year and re-rated to reflect the qualities of its electricity distribution assets. With the valuation now fairly full and the dividend yield one of the lowest in the European utilities sector, we sold the position. Finally, the position in Britvic was also sold post the bid approach from Carlsberg.

Outlook

Over the last couple of years there has been a change in the macroeconomic and political regime. Globalisation has moved to protectionism and the return of inflation has led to 'higher for longer' interest rates. The global economic outlook now seems more uncertain given the threat of a global trade war while governments are prioritising fiscal spending on defence.

Although we expect further interest rates cuts this year, the impact of the UK Budget and Donald Trump's presidency will likely keep inflation above central banks' targets hence we believe there will be a more protracted pathway to normalised interest rates. Also, corporate margins in the UK are likely to come under some pressure for domestic companies from the increase in national insurance contributions and minimum wage. However, consumers and companies have proved adept at dealing with significant cost inflation in the last few years, with UK economic growth in both 2023 and 2024 proving more resilient than originally expected. A function of this has been robust wage growth, as imbalances in the labour market continue, and the strength of personal finances and corporate balance sheets along with a very well capitalised banking system. Although UK economic growth is forecast to be lacklustre this year, strong balance sheets should continue to help support it from downside risks, while a pickup in confidence is probably needed for a better than expected outcome.

Sentiment towards UK equities remains bearish and while the UK economic outlook is subdued, the UK equity market is not necessarily a good proxy for the UK economy with 75% of revenues derived overseas. Interestingly, since interest rates started to increase at the end of 2021, the FTSE All-Share Index has returned 26.7% to the end of February 2025. Although this is behind the return of the US equity market over the same time period (+31.2%), it is still a reasonable performance given the economic and inflationary backdrop and the negative rhetoric surrounding UK equities. Despite this return, valuations are still attractive in the UK market, both compared to their own history and relative to global indices, hence we remain cautiously optimistic that UK equities can continue to make reasonable gains this year. 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

26 March 2025