Over the past couple of weeks the results season has got into full flow and enabled us to catch up with a wide range of our holdings.  As a generalisation our industrial cyclical stocks are benefitting from recent price increases and have good order books meaning that 2022 looks to be underpinned and investors are now taking into account a macro view and worrying about 2023 numbers. Our financial stocks have been marked down to market, plus a fair bit for sentiment, and our UK consumer facing stocks are proving to be rather unpopular with almost everyone.

At the moment the outlook for next year’s dividend appears to be resilient as none of the Company Directors we meet appear as bearish about the economy as the Daily Mail!Despite the challenging ‘capital’ environment for UK small and mid-caps generally our best guesstimate for our dividend for calendar 2022 remains intact at 5.55p for the B Income shares.  This equates to a yield of 5.2% ( Based on 106.85p B Income share price 2/8/2022 ) and importantly less than 5% of this income is expected to come from ‘specials’.  At the moment the outlook for next year’s dividend appears to be resilient as none of the Company Directors we meet appear as bearish about the economy as the Daily Mail!  Most are currently managing for varying degrees of slow down next year but not a prolonged period of recession and crucially, are not postponing strategic investment plans.  Looking forward corporate balance sheets are strong…we now have more companies buying back their own shares out of excess capital than we can remember…and dividend cover in the portfolio, at around 2.1X is still comfortably in excess of our long-term average, providing some wiggle room for dividend payments.

As my local sandwich shop continues to bemoan the ever increasing price of chicken…rising feed prices are the underlying cause…food price inflation, energy price increases and salary rises combined with ongoing supply side shortages have led to a perfect inflationary storm.  Whilst arithmetically the headline rate of inflation should start to fall, reduced economic growth should also translate into falling inflation and we have already seen commodity prices start to fall back from recent highs, notwithstanding European gas prices which look set to continue to be problematic.  A number of our companies have noted that the worst of the supply side logistics issues now appear to be over i.e. the log jams at ports have eased.  We have just seen one company who are moving to paying spot rates for freight costs as they believe they will be falling over the next six months or so and so do not want to lock into more traditional longer-term contracts at today’s prices.

With respect to salary inflation we have been pleasantly surprised at the ‘reasonable’ wage increases that appear to be the norm for our companies at the moment which are well below the headline rates of inflation and are coming in at around 4-5%. In most cases the emphasis has been to disproportionately favour the lower paid who also one imagines will ultimately have a higher propensity to spend the increases rather than save them. We have also seen a number of one off cash payments designed to help in the current inflationary environment but not to be paid on a sustained basis.  In the short term however meeting the rising cost of bills is undermining consumer confidence and we have seen earnings downgrades at a lot of UK retailers.  As downgrades have become more widespread there is a more general spiral downwards as analysts have to reduce price targets on stocks that haven’t been downgraded as in the ‘market’ recommendations are a relative concept.

There is little point at the moment highlighting earnings to underline how cheap we believe our investible universe to be as there is so much uncertainty about next year that our stocks may get cheaper before they bounce ….We know that it is a difficult time for our investible universe when brokers devoid of fees from equity issuance turn their attention to their other great source of income, corporate activity.  In the quiet period between the results seasons we were getting regular lists based on a whole of range of earnings, debt and cash flow parameters trying to identify which stock was next in line to be taken over.  There is little point at the moment highlighting earnings to underline how cheap we believe our investible universe to be as there is so much uncertainty about next year that our stocks may get cheaper before they bounce ….and they will bounce….and any negative statement at the moment is punished severely in terms of the share price. Interestingly though private equity have just paid hard cash for a private business similar to Vesuvius and paid a 60% premium on a look through basis to do so.

We believe that the current sell-off in UK small and mid-cap is not a re-run of the financial crisis when companies were literally having to go cap in hand to their bank managers to stay afloat.  The UK banking system is arguably over capitalised, there is a job for anyone who wants one and whilst house prices may have to adjust to rising interest rates the landing should be a soft one as the conditions leading to forced selling, the usual precursor to a housing crash, are just not in place.  Across our portfolio the companies that we invest in are financially sound and the management teams have generally improved as a result of the experiences and actions taken through the pandemic.  Anecdotally, as we would expect, management teams already have plans in place to mitigate the worst effects of falling order books by taking costs out.

In our portfolio we have just started positions in ITV and Conduit and will be adding to our holding in Inchcape after its recent acquisition, a deal which ticks all the boxes for us.  On the upside Telecom Plus has performed very well for us recently as it appears to be the only stock to benefit from the collapse of the likes of Bulb and on the downside we have recently been hit by falls in both Direct Line and Sabre as motor insurance claims inflation has exceeded all expectations.  We have retained the holdings as they both believe that conditions will normalise over the next twelve months.  This basically means that the cost of motor insurance will continue to rise significantly, a trend that most of us will unfortunately be able to confirm for ourselves. Within UK small and mid cap at the moment ‘in line’ or positive statements are being taken with a pinch of salt and anything even slightly cautious is sold off aggressively.  As managers we have been through these cycles many times before and they do provide the opportunity to upgrade the underlying quality of earnings in our portfolio as some of our old favourites start to come back into our investible universe.

Investors are looking for catalysts that may point to the worst of this uncertainty being over as share prices will start to recover a long time before economic recovery is the headline story on the BBC six o'clock news.For a whole host of well documented reasons in the last few months the macro environment has deteriorated rapidly, is forecast to get worse before it gets better and there is massive uncertainty about bottom up corporate earnings for next year.  For example Halfords came out in June and highlighting uncertainty gave a range of profitability for year end March 2023 of £65m to £75m. Apart from the fact that you could drive the proverbial bus through the spread analysts have naturally gravitated to the lower figure.  The shares fell quickly to around 140p from 190p prior to the results. Interestingly they have now clawed their way back to 173p, still substantially below the 350p we believe they are worth in the medium term.  Investors are looking for catalysts that may point to the worst of this uncertainty being over as share prices will start to recover a long time before economic recovery is the headline story on the BBC six o'clock news.  This should start when shares fall by less than earnings downgrades or even rise as the bad news is finally priced in although it is fair to say we are not there yet as we need to get a better feel for levels of corporate profitability for next year.