Dunedin Income Growth Investment Trust : Dividend growth at a time of recession

2022 has generally been a better year for dividends than most expected. Companies have increased their payouts to shareholders. However, there is a valid question as to whether this growth can continue into 2023 as the economy weakens and recession takes hold.

Dividend distributions tend to respond slowly to the broader economic climate. Companies will often hold dividends or grow them a little bit in the hope that the environment will improve. As such, it may take a while before dividend cuts come through. We might start to see more cautious messaging from companies at start of 2023. If there are dividend cuts, we're likely to start to see them in late 2023 or the full year 2024.

At Dunedin Income Growth Investment Trust, we would expect the DIGIT portfolio to be more resilient than the wider market. For the majority of the companies in the portfolio, dividend growth of 3-5% should be realistic in the year ahead.

Rates rise... but for how long?

In mid-December, the Bank of England raised interest rates by 0.5%, its ninth consecutive hike. This takes the base rate to 3.5%, its highest level since 2008. Meanwhile, inflation (as measured by the Consumer Prices Index or CPI) fell slightly but remains persistently high at just under 11% in November.

However, the Bank's Monetary Policy Committee struck a more moderate tone in the latest accompanying statement, suggesting that twelve-month inflation may have now reached its peak although expected to remain very high in the next few months. The Committee then expects CPI inflation to fall gradually into the spring of 2023.

Most of the dramatic moves in markets have been made already. Since the start of the year, investors have re-embraced 'value' companies - and moved away from faster growing, but expensive areas such as technology. In responding to the rise in rates, markets simply continued these trends.

In spite of the Bank of England's words, we still believe the interest rate environment will be difficult for certain companies next year. High interest rates and inflation create headwinds for corporate earnings, particularly for those companies with a lot of leverage. We are mindful of these risks, and careful that the companies in the trust can manage these challenges. The trust invests in quality companies, with strong pricing power and healthy balance sheets. These companies should emerge from the recession in a stronger position.

The sterling problem

The Pound has recovered some of its weakness versus the Dollar in recent weeks, having fallen for much of the year. Sterling weakness has generally been a boost for UK equities, with over 80% of revenues from FTSE 100 companies coming from overseas. Weaker sterling flatters those revenues, and may drive enhanced profit margins, stronger cash flow and dividend distributions.

That said, it has been a strain for mid-cap stocks. DIGIT has around 25% of its portfolio in that area, putting us around 10 percentage points ahead of the FTSE All-Share index. Mid-caps are often more domestic in their exposure and, as a result, it's been the weakest part of the portfolio in 2022. Some of these companies have had input costs in Dollars and revenues in Sterling. For these companies any reversal in Sterling weakness will be welcome. However, for the portfolio as a whole, the impact is largely neutral.

Portfolio changes

Volatile markets always create opportunities. The market can turn against certain sectors or individual companies, leaving the share price looking attractive for long-term investors. For much of 2022, we have been looking for areas where the market may be underestimating a company's growth potential.

Taylor Wimpey, one of the largest residential developers in the UK, is a new holding in the trust. It has an important role in addressing the structural undersupply of housing in the UK and its affordable housing division makes up around 20% of its completions.

The shares have been very poor year to date, nearly halving in value. Rising mortgage rates and poor affordability have slowed demand for new housing. We are very aware of the headwinds but believe the share price falls may have gone too far: the company has a strong order book and balance sheet, with nearly 20% of market cap in cash, plus high margins. Its high dividend yield is well-covered by earnings and the company has made a strong commitment to maintain its dividend in the event of a downturn.

Introducing Rebecca Maclean

ESG analysis is a vital part of investment decision-making for DIGIT. While we draw extensively on abrdn's broader ESG team, earlier this year Rebecca Maclean joined the portfolio management team. She brings with her lengthy experience in responsible investment, having started her career as an analyst specialising in thematic research on sustainable issues.

Rebecca has also built up expertise as a UK equity fund manager, working on abrdn's sustainable and ethical open-ended funds. These skills make her a perfect fit for DIGIT as we look to embed sustainability into every investment decision we make.

Companies selected for illustrative purposes only to demonstrate the investment management style described herein, and not as an investment recommendation or indication of 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 abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen's Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.

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