March was a very difficult month for the portfolio and the wider UK equity market. The Trust’s net asset value fell 26.5% on a total return basis, underperforming its benchmark the FTSE All-Share which fell 15.1% and the AIC UK Equity Income Sector which fell 19.4%.

The Lowland portfolio is more exposed to medium and small companies in the UK than the FTSE All-Share benchmark. This is a deliberate allocation decision as in our view small and medium sized companies will, over the long term, grow earnings and therefore dividends faster than larger companies (by virtue of being smaller and at an earlier stage of their life cycle). During March, however, small and medium sized companies materially underperformed larger companies. Smaller companies are on average more domestic and more cyclical in their exposure (small companies tend to be more exposed to retail, industrial and construction end markets, for example, whereas companies in more defensive sectors such as utilities, consumer staples and pharmaceuticals tend to be larger, more established businesses). The portfolio, partially because of its small and medium sized company exposure, is therefore more exposed to the domestic and global economy at a time when large parts of the global economy are effectively being temporarily mothballed as a result of the virus. This will cause substantial future earnings downgrades in cyclical sectors such as industrials, and share prices are moving down ahead of this.

One of the areas most severely affected by the virus has been civil aerospace, where we have two companies in the portfolio that are materially exposed – engine maker Rolls-Royce, and components producer Senior. In the short term, plane production schedules from Boeing and Airbus are likely to be substantially curtailed, while reduced flying hours because much of the world’s aeroplane fleet is currently grounded will substantially reduce necessary servicing work and repairs (negatively effecting Rolls-Royce). This will mean earnings downgrades for the aerospace names held within the portfolio and the share prices have been weak as a result. Over the long term we think older planes will need to be replaced on environmental grounds and planes will be ungrounded, but undoubtedly the short term earnings outlook is poor.

We are using this period of share price weakness to add to existing holdings that we know well and have followed for a long time. During March this included adding to industrial Morgan Advanced Materials, insurers Aviva and M&G and housebuilder Bellway. We also took up a placing in bowling alley operator Ten Entertainment to give them an additional runway of cash while all their UK sites are closed. In order to fund these purchases we reduced the positions in RBS and HSBC. Both were held partly on the prospect of capital returns to shareholders and this looks increasingly far in the future in the current environment. The position in Royal Mail was also sold. It had performed well on a relative basis this year on the hope of growing delivery volumes but on a longer term basis has a structurally declining letter business and it is struggling to shift its delivery network to accommodate parcels rather than letters.

This year will be difficult for investment income. There have been a substantial number of dividend suspensions in the portfolio from a broad range of companies including HSBC, Lloyds Bank, Morgan Advanced Materials, Johnson Service Group, Halfords and Hill & Smith. We expect further dividend cuts in the coming weeks as companies seek to preserve cash given the highly uncertain outlook. Some companies we think will continue to pay dividends, for example utility companies, pharmaceuticals and some insurers, but other sectors such as banks will not pay for the remainder of this calendar year. While we support the Boards and management teams in this decision as a long-term shareholder, and do expect dividends to be restored (albeit in some cases at a lower level) next year, this does present a difficult outlook for income. Lowland has substantial revenue reserves that it has not used since the financial crisis that could be used to ‘smooth’ dividends in difficult years such as this one. However, this is a Board decision and we will continue to reassess the income forecast throughout Lowland’s financial year (which ends in September).

Glossary

Net asset value: The total value of a fund’s assets less its liabilities.