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Henderson High Income outperforms during a more challenging year

221221 HHI does what is says on the tin

Henderson High Income (HHI) has announced its annual results for the year ended 31 December 2022, which proved to be a more challenging period, after 2021’s strong performance. During 2022, HHI provided NAV and share price total returns of +-1.9% and -1.1% respectively, although this was superior to its composite index which provided a total return of -3.3%. 2022 was a difficult year for financial markets as they responded to the highest rate of inflation in 40 years (a consequence of the war in Ukraine, the surge in global energy prices and considerable disruption to supply chains around the world) with central banks announcing significant interest rate increases. This caused a sharp sell off in both global equity and bond markets as yields rose. Within the UK market the additional impact of the mini-budget announcement in the autumn was significant and caused a sharp fall in UK government bonds and alternative assets as pension funds were forced to raise liquidity. Against this backdrop, the UK equity market was relatively resilient – the top stocks generated a positive return, albeit medium-sized and smaller companies fared less well.

Dividendboard confident of ability to maintain a high dividend

HHI’s board says that the current period of high inflation makes this objective of paying a high dividend stream even more important. Although financial markets were volatile in 2022, the recovery in corporate dividends continued and the total income received by HHI during the year exceeded its payout, enabling HHI to increase its revenue reserves. At the end of 2022, the company held £8.8m of reserves, equating to around 8 months of current dividend cover. The board says that, whilst at this stage of the financial year and particularly given the uncertain economic backdrop it is sensible to be cautious about overall income levels for 2023, the current level of reserves continues to give it confidence in HHI’s ability to deliver a high level of income to shareholders. During 2022 the board recommended the payment of dividends totalling 10.15 pence per share, an increase of 2.0% over the payment in 2021. This increase represented the 10th consecutive year of dividend growth from the trust, making it an AIC next generation dividend hero.

Performance – HHI benefited from equities overweight

The overweight position in equities relative to bonds versus the benchmark contributed to HHI’s relative outperformance, as did the outperformance of the individual stocks within the bond portfolio. HHI’s equity portfolio fell 1.3% on a total return basis during 2022, underperforming the All-Share Index return of 0.3%. Although the portfolio includes shares in oil majors BP and Shell, the percentage invested in oil companies is less than that in the benchmark index, hence the significant outperformance of the oil majors proved detrimental to HHI’s relative performance. The portfolio’s positions in Hilton Food Group, Intermediate Capital and Big Yellow were also detrimental to performance. HHI’s manager, David Smith, comments that all three companies have been successful long-term holdings for the trust, but saw their share prices underperform in 2022. Hilton Food Group’s profitability was impacted by cost inflation in its seafood business, which it was unable to pass through to customers. Despite reporting strong results in the period, Intermediate Capital underperformed over fears that rising interest rates and slowing economic growth would lead to the company being forced to mark down the value of its investments in private credit markets. Finally, self storage company Big Yellow also reported good results during the year but the share price was impacted by the significant rise in bond yields, which led to a de-rating across the real estate sector.

HHI’s equity portfolio also suffered from its exposure to more domestic cyclical businesses, such as housebuilders Persimmon and Vistry. Both shares underperformed during the year as investors feared that higher interest rates and the end of ‘Help to Buy’ would slow demand for housing, and this was exacerbated in the aftermath of the “mini-budget” in September, which saw mortgage rates surge and cancellation rates rise.

On the flip side, the portfolio’s holdings in British American Tobacco and Imperial Brands were positive for performance. David comments that both of these holdings benefited as investors sought out companies with relatively defensive earnings, amid fears over slowing economic growth. Imperial Brands was further supported by better operational performance after a number of disappointing years, and its intention to start buying back its own shares. HHI’s overweight position in NatWest benefited performance after the bank announced good results with better net interest income given higher than expected interest rate sensitivity. NatWest also upgraded its medium-term profit targets and announced a £1.75 billion special dividend.

Elsewhere, holdings in Burberry, Anglo American and Devro made positive contributions to performance. The announcement of Daniel Lee as Burberry’s new Creative Director was well received, while the share price was further supported by rumours that China could relax its zero Covid policy which had curtailed growth for the company in the region. Anglo American also benefited from optimism that Chinese economic growth could accelerate, supporting commodity prices. Food casings manufacturer Devro, a new holding in 2022, saw its shares surge after the company was subject to a bid approach by Saria Nederland at a 65% share price premium.

Although the fixed income portfolio fell by 7.7% on a total return basis during the year, it significantly outperformed the 17.8% fall in the ICE BofA Sterling Non-Gilts Index. The portfolio benefited from its exposure to US investment grade credit, given its outperformance versus UK corporate bonds, while the dollar’s strength increased the value of the bonds to sterling investors. The portfolio was also aided by its holdings in some short duration high yield bonds, such as Crown Americas (packaging), Aramark (food services) and Service Corp (death care services), which were less sensitive to interest rate moves.

Income review

2022 was another positive year in terms of UK market income with aggregate dividends growing by 16.5% on an underlying dividend basis (ex special dividends) according to the Link UK Dividend Monitor. This was primarily driven by strong growth in dividends from banks and oil & gas companies, albeit overall dividend payments for both are still below their pre-pandemic levels. HHI’s income return also showed good growth, increasing to 10.37p per share, from 9.44p in 2021. While dividend payments from mining companies Rio Tinto and Anglo American reduced in line with falling commodity prices in the first half of the year, this was offset by good dividend growth from Lloyds and NatWest in the banking sector, and from oil majors BP and Shell. NatWest also paid a large special dividend in the year, as did Victrex, Volvo and PageGroup. In total, HHI earned £1.1m in special dividends in 2022.

After two years that required a small portion of funding from revenue reserves, HHI’s dividend was fully covered by underlying earnings in 2022, with an excess £384,000 being added to revenue reserves. During the year, the board increased the dividend to 10.15p, growth of 2% over 2021 (9.95p). The trust has now raised its dividend for ten consecutive years at a compound average growth rate of 2.0%, in line with the long-term historical average for UK inflation (as measured by CPI). Revenue reserves as at 31 December 2022 were £8.8 million, providing 67% cover over the company’s dividend as at 31 December 2022.

Portfolio activity

During the year, a net £6.6m was added to the bond portfolio, specifically US investment grade credit, to take advantage of the move higher in yields and widening of credit spreads. Bonds were purchased in typically higher quality, non-cyclical businesses such as Abbvie (pharma), Amazon and T-Mobile (telecommunications). Further additions were made to the bond portfolio in October after the move higher in UK gilt yields caused by the “mini-budget”, including high quality UK investment grade credit from issuers such as Brown Forman, AB Inbev (both beverage companies), Nestlé and Sky. The bond portfolio represented 11.0% and 13.6% of gross and net assets respectively as at the end of December.

Gearing was reduced during the year with approximately £8m of borrowings paid down. This was funded by the sale of more cyclical businesses within the equity portfolio, including Ashmore, Informa, Volvo and TI Fluids. Investment performance at emerging market debt manager Ashmore has been poor, and with fears that Russia’s invasion of Ukraine could cause more volatility in emerging markets debt markets and further outflows, the position was sold. Informa shares had performed well since the pandemic lows and the valuation had risen to discount a full recovery in its events business, but HHI’s manager was concerned about the potential of further lockdowns in China and slowing economic growth further afield and decided to capitalise on that recent outperformance. David Smith comments that European truck manufacturer Volvo is a well-managed business but has high operational gearing, hence any slowdown in the trucking and construction markets could have a significant impact on its profitability and limit cash returns to shareholders. Finally, TI Fluids supplies parts to the automobile market, and the position was sold due to fears about the long term sustainability of its fuel tanks division given the long term transition to electric vehicles. With the company having a set dividend pay-out ratio based on annual cash flow, a fall in profits would likely lead to a cut in the dividend.

Within the pharmaceutical sector the manager made a number of changes. Following its demerger from GSK, the position in Haleon, its consumer health division was sold. David says that the company’s balance sheet is stretched and with the dividend yield low as the company prioitises debt reduction, he feels that this does not fairly compensate shareholders for the elevated risks. The holding in GSK was also reduced to an underweight position when news of potential Zantac (medication for indigestion) liabilities started to emerge. A new position in Sanofi, the French pharmaceutical company, was added, given its low valuation relative to its potential future earnings growth (supported by the success of Dupixent, its treatment for eczema), and continued cost rationalisation.

Elsewhere new positions in Woodside Petroleum, Spectris and HSBC were initiated. Following Woodside’s merger with BHP’s oil & gas assets, the business is well positioned in low-cost, long-life LNG (Liquefied Natural Gas) assets in Australia and high margin oil production in the US Gulf of Mexico. Woodside’s leverage to LNG is particularly attractive as it is seen as a “transition” energy due to it emitting less carbon than coal or oil but being more efficient than renewables, which means that it should continue to be in demand from emerging markets over the long term.

Spectris develops precision instrumentation and controls for various industries. It has a strong franchise in specialist niche markets and following the sale of a number of low growth and low margin divisions, the remaining business is better quality, with higher and more stable margins and returns. HSBC has strong franchises in retail and commercial banking in the UK and Asia (ex Japan); the company also has a strong capital position, with profits benefiting from an increased net interest rate margin on its large deposit base and supporting good dividend growth.

Outlook

David Smith comments that markets rallied from their October lows as inflation has shown signs of slowing, leading to hopes that central banks may pare back further increases to interest rates. In addition, falling European gas prices have eased fears about an impending recession, and China has relaxed its stringent zero Covid policy. However, the impact of the rapid rise in interest rates globally is starting to be felt with some weaker banks in the US and Europe getting into financial difficulty. This will undoubtably lead to a higher level of volatility within equity and bond markets even though consumer and corporate balance sheets are strong, UK banks are well capitalised and unemployment remains low.

Although disinflationary forces are now emerging, David thinks there are reasons to believe that inflation will settle at levels higher than we have been used to and be more volatile in the years ahead. Labour markets remain tight, putting upward pressure on wages, while the move away from globalisation towards protectionism, the reshoring of manufacturing facilities and the move to net zero will all add to inflation in the developed world. Hence it is the manager’s belief that the age of ultra-low interest rates is over, and that the global economy is moving to a new more normalised world for interest rates. After an extended period where investors sought growth irrespective of value, now that the era of “free money” is over, asset valuations will become increasingly important once again.

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