The Edinburgh Investment Trust Plc Annual Financial Report 2022 - Flipbook - Page 13
THE EDINBURGH INVESTMENT TRUST PLC / STRATEGIC REPORT / 11
DIVIDENDS
After the dividend cuts that many companies announced early
in the pandemic, it seems reasonable from today’s position that
the UK market should in total produce dividend growth of about
3% per annum over the medium term. This would be somewhat
less than the market weighted average growth in pre-tax profits,
which should be something akin to Eurozone nominal GDP of circa
5% per annum. The difference between these two numbers is
explained by the headwind from rising UK corporate tax rates.
We have worked through a range of different scenarios with the
Board. While making estimates is particularly fraught at present,
there are in fact two factors in which we have high confidence.
The first is that we expect the boards of operating companies to
be cautious about future dividend increases. After the various
‘black swans’ of recent years – Brexit, supply chain difficulties,
Covid, Ukraine – they are unlikely to push for sizeable dividend
increases after adjusting for inflation.
The second factor is the strength of the Company’s balance
sheet. With stated revenue reserves of £50.8m at the year end,
this provides a buffer for current shortfalls in income versus
dividend expenditure.
Overall, we remain of the view that, after taking into account the
Board’s decision to increase this year’s dividend, the Company’s
net revenues – underpinned by the operational features described
above – should begin to cover the cost of the dividend in the
medium term. The current position of the Company’s income
profile, along with its strong balance sheet, should enable the
current growth trajectory to be maintained.
BORROWINGS
The Company carries a modest amount of gearing. This should
boost returns to shareholders, assuming positive underlying
portfolio returns. Net gearing has been reduced since the half
year stage, when it stood at 7.7%. This reflects the various
uncertainties: Ukraine, rising interest rates, inflation. Net gearing
was 4.4% at the year end. As the Chairman described in more
detail, attractive new funding is due to come on stream this
September. We expect to put more of this capital to work in
the months ahead, particularly if the current market weakness
persists.
LOOKING TO THE FUTURE: WHY INVEST IN THE
UK EQUITY MARKET?
This is a question we are often asked. Our short answer is that
the opportunity set remains huge and there are multiple factors
underpinning our medium term confidence. There are inevitably
risks too: the war in Ukraine, plus factors such as ongoing supply
chain issues, make the shorter term harder to predict. But for
now we observe that the UK equity market has regained its mojo,
but the valuation on a whole host of metrics is still low relative to
many markets.
The factors driving the low starting valuation are unduly skewed
towards muscle memory: factors that are firmly in the past,
less evident in UK quoted companies or of rapidly declining
impact. Taking each in turn: first, the prolonged uncertainty
around Brexit. It was difficult enough understanding the range of
outcomes as a UK voter. It is therefore unsurprising that global
investors parked it in the ‘too difficult’ category and gave the UK
market the proverbial long spoon treatment. But that is over –
quoted companies can live with the reality of Brexit. Second, UK
productivity lags our major peers – this may well be right at a
macro level but the companies we invest in certainly do not lag
their peers. Third, the long trend towards global equities – which
in reality means buying the US given it makes up about 60%
of global benchmarks – and pension scheme de-risking which
amounts to selling equities and buying bonds are both decreasing
in intensity. The starting point of underownership and skinny
positioning is a good set up for the current trends.
So what are the trends? Economies are late cycle and central
bankers are looking to raise interest rates and where applicable
shrink their balance sheets in order to reduce inflation
expectations before they get entrenched at higher levels. All this
is not easy with actual inflation rates reaching generational highs
and more in the pipe near term. One of the economic effects
of the tragic events in Ukraine is to layer yet more inflation on
already high inflation. Food inflation is one of the myriad examples
consumers face.
Input cost inflation combined with waning corporate and
consumer confidence means earnings downgrades but the
downgrades could well be greatest in a number of the faster
growing segments of the market. Here the UK market scores
highly as its “par earnings run rate” has over the last few years
lagged the US. What investors consider to be a competitive run
rate of earning per share is likely to take a step down and the
UK will be back in the running. Markets are often about rates of
change and changing perceptions. So that ticks off a recurrent
concern that the UK doesn’t have any growth shares. Not only is
it off beam – as the Edinburgh portfolio itself illustrates – but it is
also less relevant for the current environment.
The next concern from some investors about the UK is that the
market is full of banks, international energy companies and miners.
This is seen to be the Achilles heel. Again taking each in turn:
banks – it has been a long work out since the Global Financial Crisis
(“GFC”) in 2007-08. Regulators have forced capital raises, profits
have been eaten up in conduct charges – remember PPI? – but
that is all over. A good example is NatWest which is seeing profits
convert into distributable cash and has a chunky dividend and an
ongoing buyback programme. These purchases are being done
at a discount to its accounting value: a compelling level. Next up
are the international energy companies. The Russian invasion of
Ukraine has shown that it matters where energy comes from.
Shell is ranked number one in globally traded liquefied natural
gas. It could well generate up to 40% of its market capitalisation
in cash over the next three years. A good chunk will be reinvested