In this episode of the abrdn Investment Trusts podcast, we hear from Ian Pyle as he discusses how the portfolio has evolved over the past year, and the prospects for the year ahead.
Transcript
Cherry Reynard:Hello and welcome to this abrdn Investment Trust podcast. I'm Cherry Reynard. Today I'll be talking to Ian Pyle, manager of the Shires Income Investment Trust. We'll be looking at how the portfolio has evolved over the past year, and the prospects for the year ahead. Welcome Ian.
I wonder if we could start with a quick reminder of the fund's aims and objectives and kind of the underlying philosophy of shires
Ian:Hi there Cherry, yeah, of course. So, when we think about the objectives for Shires, the main one is really to deliver sustainable defensive income to our shareholders. So that's the most important thing. That's what we focus on most. And as it stands, we have a dividend yield of over 5%. So an attractive premium to the market. And that's proven to be defensive over time. So that's the main thing we focus on.
With Shires we try and maintain a balance between that high yield and that high level of income and capital growth over time. So we try and deliver some growth as well. The structure of the portfolio allows us to do that, because we've got about 30% of our position in preference shares, which are very high yield, that gives us a little bit of freedom to buy more growthy things to have slightly more differentiated positions where we're not as worried about the headline yield in the equity portfolio. And over time, that's proven to be quite successful in delivering that really nice balance between a high level of income but also growth.
Cherry:Great. And so what does that look like in practice? I mean, are there any significant themes running through the portfolio today, any sort of key positions you'd highlight?
Ian: Yeah, so when we think about positioning for the portfolio, we need to think about it in the overall context. So, we've got a couple of kind of fixed anchors in the portfolio. You've got the preference shares, which tend to be high yield, they can be very defensive. But they won't deliver growth and capital return in the same way than equity will. Then we have about 10% of assets in an abrdn smaller companies income trusts, which gives us exposure to really high growing parts of the market, smaller companies, which will deliver long term capital growth, which definitely has a very good long term track record.
But both those two anchors - the preference shares, and the smaller companies trust, tend to perform less well when you have more of a value rotation in the market. And they tend to perform less well, when you get a rising bond yields, which is what we've seen year to date. So in the remaining equity portfolios for the majority of the assets, we've tried to create that balance. And if we think about a theme that's developed over the last year to 18 months, it's been to shift that equity portfolio to be slightly more value weighted, to have more sectors and more companies that will perform well in environments of rising bond yields and rising inflation.
And that's proven to work quite well, this year. It's been a nice hedge, as we've seen the market rotate quite dramatically so far.
If we put that in terms of sector exposure, then in equities, we're overweight energy, we're overweight financials and insurance - sectors, which have that slightly more value skew, they have nice high incomes, and they will perform well through an inflation scenario. And we're underweight some things like consumer staples, where we don't see high yields, and where we see a natural decline in equity values as bond yields go up. And that theme and that positioning with the equity portfolio, it's something we've been transitioning towards probably over the last two years, but particularly over the last 18 months and has been a clear, clear movement for the portfolio.
Cherry:And what is driving that transition? I mean, obviously there's a higher interest rate environment, higher inflation environment, and then we've had, you know, the disruption from the crisis in Ukraine, is it sort of conflation of all of those things?
Ian:Yeah, it is. I mean, it's been an extremely interesting time for markets and you know, quite a difficult time, I think so far year to date. And, as you say Cherry, all those things have kind of come together to cause quite a marked market rotation. Our view from last year was that we had a period of falling bond yields for 10 years, and that had obviously led to significant outperformance for growth stocks and for stocks with long duration cash flows. And as a Trust, we've certainly benefited from that -we've held things which are those kinds of assets gross long duration stable cash flow producers, which have performed well over the last 10 years.
But that - that almost needed to change I think and the COVID 19 pandemic accelerated that because you ended up with a situation where suddenly, demand rebounded strongly across all sectors of the economy and supply was quite constrained. And that creates inflationary pressure we've seen inflation come through even before the start of this year.
And that leads to a change in central bank policy, rising interest rates, increasing bond yields, which then drives that rotation in markets that we saw in January and February this year. The crisis in Ukraine, which is, you know, first and foremost, terribly unfortunate and tragic humanitarian situation - from an investment perspective, exacerbates that rotation because you have more restrictions on supply of energy. And also soft commodities, which comes through in food prices, all of that is quite inflationary. And although it creates a lot of risk for the economy, it feeds through into that need for central banks to be more hawkish on policy and create an environment for equities, where suddenly duration of cash flows is less of a benefit than it was. And we see that wide valuation gap between growth and value, normalising and continuing to do so. So definitely, those things have come together to create a really sharp rotation, and it's been certainly sharper and more marked than we would have expected coming into this year
Cherry:And, obviously, markets have been very volatile since the start of the year. And it's kind of difficult to talk about opportunities at a time of crisis. But has that volatility bought any opportunities, you know, to access sort of high quality companies at low prices for example?
Ian:I think, I think it has done Cherry. I think, you know, obviously, coming into the year, we would have argued that a lot of the growth, the high quality equities were overvalued, and naturally those valuations have corrected downwards. That creates opportunities, I have to say I don't feel we're quite there yet at the point where that valuation gap has closed, and we're buying high quality, more highly rated stocks today. But we're starting to see some that look more attractive. And that's something we'll definitely keep our eyes out for because we want to own those high quality stocks where we can own them for the next five to 10 years, and they'll deliver real growth and benefits for the portfolio.
I think the nice opportunity from an income point of view is that actually, we could own some high yielding names. And they don't have that headwind of falling bond yields and fairly persistent under performance which is what we've seen over the last extended cycle.
It's always felt like there's that trade off that if you want to buy income and buy yield, which is what we need because we want to deliver that sustainable income to shareholders. You have to accept that those stocks are probably going to underperform. And the playing field feels like it's been levelled out a bit this year. So we can buy high yielding names, particularly in energy and financials, deliver a high level of income, but also get some outperformance relative to the market in terms of the share prices. So that definitely throws up opportunities for us. And we've been buying things like - we've been adding to energy, we’ve been buying things like banks, where they will be natural beneficiaries of rising interest rates, where capital positions are really strong and where we will get notable income in the next one to two years.
Cherry:And what about the sentiment towards the UK market as a whole? I mean the UK has been so out of favour and even at moments when it looked like it was kind of coming back into favour it would then sort of slip out again. But it seems like this rotation would favour UK markets again? Have you seen that happening in practice?
Ian:I think you're absolutely right. I think we've definitely seen the UK come back into favour. We've seen interest in UK equities pick up and I think that's the right thing. You know, I think suddenly the UK is weighting towards commodities, financials, utilities is very helpful in an environment of rising bond yields and inflation because they are the best inflation hedges and they're also quite defensive in the outlook we see ahead. So, there's a good reason why the UK has outperformed other developed markets year to date.
It also benefits from suddenly not having that big weighting to tech or gross that has held it back in recent years because t hose are the sectors that are derating most quickly at the moment. So the UK side looks more attractive, it remains a really compelling source of income relative to other markets. So the, the yield from the UK is better than you'll get elsewhere. And it should be relatively defensive income as well. So there's an attraction to holding that, particularly at a time of inflation, when you see the real value of cash in a bank account, going down as inflation goes up, actually holding defensive equities, which can provide a high level of yield is, is a really good place to be in the UK market is a good way to do that.
Cherry:And Ian, inflation has obviously been a huge topic and it looks like inflation is going to continue to accelerate, at least for the next few months. How are the companies you're invested in, how are they handling it? Are you finding that they are able to pass on, you know, higher input costs and higher energy costs? And how are they sort of handling things like supply chain disruption?
Ian:Yeah, it's a great question Cherry. And it's definitely front and centre of every meeting we have with company management teams over the last over the last six months.
I think we've definitely moved from a debate last year about whether inflation would be transitory to one of, you know, how high can it go? And how long will it stay at that elevated level? Clearly, there'll be some elements of inflation, which can't repeat. So high energy costs that we've seen, they probably won't, we won't see the same kind of year on year increases as we move forward as we are at the moment. So that will abate to some extent, but in my view, is we're getting to the point where inflation is becoming more embedded into the economy. So we're seeing wage inflation come through. And generally when you see wage inflation, and you set employees expectations for wage increases, then inflation does become quite persistent. And it takes time to change that. So it's something we're going to have to deal with, companies will have to deal with it. And we'll have to think about positioning in response to that.
Generally in Shires, we look to own high quality companies and one of the aspects that we look for to assess a company's quality is their pricing power and their market positioning. So we want to own companies where they have a strong market position where they will therefore have the ability to pass through inflation to their customers. So that should protect us.
In a lot of the sectors where we're overweight, I think, are naturally well, well set for this environment. So energy, obviously should be a beneficiary of energy inflation. Then, in financial, certainly in banks, we'll see interest rates going up, which is a straight benefit for them. And there's not a lot of input cost inflation for banks to worry about other than wage inflation so they can manage it.
We're underweight areas like retail, for example, where you see rising supply costs, but you also see pressure on the consumer and therefore downward pressure on demand. And they tend to be the companies particularly if they don't have a really strong competitive positioning that get squeezed in this environment. So we'd be cautious on retail as a sector. And then consumer staples, another sector where we're underweight, you see that same dynamic and input costs going up and the ability to pass that through to consumers being more limited.
Most of the companies we meet, they're actually reasonably confident about the ability to pass through inflation at the moment. We'll see how long that lasts. I think there's a period of time now where consumers and companies have quite high cash balances. So their ability to take some pain in terms of price rises is quite strong. As it gets more persistent, then that ability to soak up price increases, decreases naturally. So, we just want to make sure we're positioned in good quality companies, and we're well exposed to those sectors that will be beneficiaries of inflation going forwards.
Cherry:Okay, great. I think that you might actually have answered this question. But, you know, just just bringing everything together. So I mean, how optimistic are you on the UK stock market for the year ahead? And do you see sort of notable areas of strength in areas that, you know, investors really need to avoid?
Ian:I think, I don't want to sound too optimistic on markets overall, because I think we can see the risks increasing, you know, increased inflation. And for a lot of companies, higher input costs and concerns over consumer demand are becoming more and more apparent. So the risk of the economy slowing and that feeding into stock prices is definitely there. It's something we need to be very aware of.
I think, offsetting that, there's reasons to be more optimistic as well, you know, unemployment is very low. Consumers and companies have very high cash balances, they're well hedged against the period of disruption that could come up. And we've seen valuations correct, particularly in the more highly valued segments of the market already, so I wouldn't be too bearish overall, I do think the setup particularly benefits the UK market relative to other markets. And we've still got this really wide valuation gap for the UK versus other developed markets, that means it should perform well year to date and deliver a higher level of income. So I think there's a good reason certainly to be optimistic on the UK market relative to other things. We've just got to be aware of the risks and Shires as a Trust has got a very good defensive track record, it tends to outperform in a period where the market goes down quite strongly. And it's proven, certainly through the pandemic period where income expectations for the market got cut substantially, that we can protect the dividends through that period. So as long as we focus on delivering those defensive characteristics, and making sure we try and protect the income from the Trust, then I feel optimistic that the outcome and certainly on a relative basis for this year.
Cherry:Great. Okay, that seems a good note to end on. Okay. Thank you, Ian, for those insights today. And thank you to everyone for tuning in. You can find out more about the trust at www.shiresincome.co.uk.