Troy Income & Growth PLC Half Year Report to March 2021

INTERIM BOARD REPORT

Performance

The Company delivered a Net Asset Value (NAV) total return of +2.6% and share price total return of +1.1% over the six months to 31 March 2021. Over the same period, the FTSE All-Share Index produced a total return of +18.5%. The weighted average NAV total return for the AIC UK Equity Income sector over the six months to 31 March 2021 was +20.9%. Both the Board and the Managers recognise this significant relative underperformance which erodes the hard-won relative outperformance generated in the previous two years.

As noted previously, the Board remains predominantly interested in long-term performance. Although the impact of this short but sharp period of relative underperformance is that over three and five years the Company's performance now lags behind the market, over ten years the Company's NAV has significantly outperformed the FTSE All-Share Index.

A quarterly rate of 0.49p per share was paid for the first and second interim dividends and the Company expects, barring unforeseen circumstances, to maintain this rate of distribution for the current financial year.  Further details of the Board's outlook for dividends are contained later in this report.

Background

The first weeks of the Company's reporting year were characterised by many of the same equity market drivers that had influenced markets through the summer of 2020. However, the early November announcement of compelling COVID-19 vaccine efficacy data marked a sharp and significant change in sentiment. The breakthrough significantly truncated downside risk for investors and led to the market valuing companies based on more normalised levels of profitability, thereby acting as a starting gun for a rotation towards more cyclical assets.

Investors' optimism was further excited by the resolution of a bitterly contested US presidential election and the expectation that a newly empowered Democratic party would pursue a policy of continued fiscal and monetary largess.  On this side of the Atlantic, a trade agreement was eventually reached between the UK and the European Union.

The ensuing increase in risk appetite has been felt across many asset classes. Government bond yields have risen sharply over the last six months, the oil price (WTI) has risen 47% to nearly $60 a barrel, and Iron Ore and Copper prices have both risen over 30%. For equity investors the most dramatic manifestation of this has been the sharp change in market leadership. More cyclical and asset-intensive companies, many of which were among the most aggressively marked down following the emergence of the pandemic, have risen sharply. This is illustrated by the 6 months returns from the Banks and Oil & Gas sectors¹ which rose 56.6% and 42.4% respectively. Both are still more than 20% below their pre-pandemic levels. Meanwhile, higher quality companies, which we define as those that exhibit higher returns on capital and lower levels of volatility, have been jettisoned by investors looking to participate in the repricing of more value orientated stocks. While many of these higher quality stocks had been more resilient in the face of COVID-related disruption, this rotation has meant the return from the Consumer Staples sector over the reporting period has been a modest +4.1% whilst the equivalent Healthcare index has fallen -9.4%. Over 10 years however, Healthcare and Consumer Discretionary stocks have both in aggregate more than doubled while Banks and Oil stocks have delivered negative returns.

Portfolio

The environment described above has created an exceptionally challenging period for the Managers' investment style which aims to seek out and invest in high-quality companies with predictable long-term growth profiles. Although your portfolio contains a number of companies that have benefitted from the development of a vaccine, most notably within the portfolio's allocation to Consumer Discretionary stocks which includes holdings such as Next and Compass Group, the positive contribution from these holdings has been all but offset by a marked derating in a number of the portfolio's core quality growth investments. 

The Company's long-term investment horizon means that the Managers have used the opportunities created by events, including both the volatility that investors experienced this time last year and the more recent shifts in relative valuation, to buy new investments that offer higher dividend growth such as Diploma and InterContinental Hotels, as well as add to core holdings including Diageo, Experian, Reckitt Benckiser and Unilever. Whilst many of these core holdings have seen significant share price headwinds, their underlying profitability and long-term value generating capacity remains undiminished, meaning they now trade at what the Managers deem to be very attractive valuations.

Discount Control Mechanism

The Discount Control Mechanism (DCM) was active during the period with the Company repurchasing a net total of 11.3m shares. These shares are now held in treasury. The DCM was implemented in 2010 in order to provide liquidity to both buyers and sellers of the Company's shares and to maintain the close linkage between the price of those shares and their underlying NAV. The DCM reduces discount volatility which remains much lower than for the peer group as a whole. All transactions are NAV enhancing. 

Gearing

The Company had a £20 million gearing facility with ING that expired on 24 April 2021. The facility was not utilised during the period, reflecting the Managers' conservative investment style and desire to keep the volatility of returns relatively low. The Board and Managers will keep under review the possibility of a new gearing facility but meantime the Company will save the cost of maintaining such a facility.

Dividends

The current quarterly dividend rate is 0.49p per share and the second quarterly dividend was paid on 23 April 2021. The imposition of a second national lockdown shortly after the start of the period and the associated impact on corporate cash flows means that a number of portfolio companies have yet to recommence dividend payments. This continued disruption to the portfolio's income means it is probable that the full year dividend will be partially paid out of reserves. The current dividend rate continues to represent a level of distribution that reflects the potential income generating capability of the underlying portfolio and a base from which the Company can, once more, grow its dividend.

The Management Team

In February of this year, Troy Asset Management ('Troy') announced its succession plans for Francis Brooke who will be relinquishing his fund management responsibilities and taking on a new role as executive Vice-Chairman of Troy on 31 December 2021. Hugo Ure and Blake Hutchins will continue to co-manage the Company after Francis steps down. The Board has been aware and supportive of the succession plans for some time and looks forward to a well-managed and seamless transition.

Outlook

As an Investment Trust focusing explicitly on investing in resilient, compounding businesses, the last six months have undoubtedly been challenging in relative performance terms for Troy Income & Growth Trust. Long-standing investors will be aware that divergence from the market has been a feature of the Company's returns over the years, often to the benefit of shareholders but also occasionally to their short-term detriment.  Such periods have proved short-lived in the past and when navigated sensibly, provide the Managers with opportunities to purchase shares in high-quality companies, capable of multi-year dividend growth, at attractive prices. As ever, uncovering such opportunities remains their priority, and they have added selectively to both new opportunities and several of the exceptional, resilient companies that already form the core of the portfolio. It is expected that these additions will not only further strengthen the long-term dividend growth prospects of the portfolio but also drive future capital returns.

Following a period of significant stock market strength, in which returns have been primarily driven by a recovery in a relatively narrow group of pro-cyclical companies, it is reasonable to anticipate a broadening of market returns looking ahead. Over the past six months, mining companies, energy companies and banks have dominated UK large-cap returns, whilst more stable businesses have either struggled to keep pace or have been sold off as a violent repositioning trade reversed some of the trends that occurred in the more risk-averse markets of early 2020. Following a meaningful re-pricing of expectations, it is noted that many cyclical companies have recently moved towards or beyond peak enterprise value, whereas the shares of many of the sustainable dividend growth stocks favoured by the Managers now trade at levels of free cash flow yield which have previously been a precursor to more attractive absolute returns. With valuations across equity markets now more balanced, the Managers judge relative risk/reward on any reasonable time-frame to be in favour of higher-quality, growing businesses.