Managing Directors Report

"Time is the friend of the wonderful business, the enemy of the mediocre." Warren Buffett - Letter to Shareholders 1989

"When America sneezes, the rest of the world catches a cold" Circa 1920

After the turmoil of recent years, many had hoped that 2022 would see a return to a more normal environment.  However, the year so far has been punctuated by macro events such as the crisis in Ukraine and interest rate rises. In the US, investors are clearly fearful of inflationary pressures and the resulting US Federal Reserve's (The Fed) policy response.  Accordingly, the US equity market recorded its worst first half period in 60 years, shifting the market into bear territory and, unfortunately the Fed has signalled more rate hikes are to come, noting the difficulty of bringing down inflation without triggering a recession. Despite the economy slowing with early signs of a recession evident, the US labour market continues to remain strong with unemployment holding steady at 3.6%.  Wage growth has not kept up with inflationary pressures with US inflation rising +8.6% compared to a year ago.

Similarly to what occurred in the 1920's and the 1950's the beginning of the tightening cycle by the Fed is also impacting the equity markets globally, which have had a volatile start to the year.  The S&P500 declined by 20.6%, with the Nasdaq materially worse, declining by 29.5% over the past six months.  In Europe, specifically the ongoing Ukraine conflict continued to drive declines in Eurozone equities as concerns relating to gas shortages continue to rise. Ongoing disruptions saw Germany shift into phase two of its emergency plan, with the next steps being to ration gas supplies. High inflation and the increasing cost of living are affecting consumer confidence in an environment when the Central Banks are expected to raise rates in the coming month.

In the UK, while the Bank of England increased its official rate by a combined 50 bps, the FTSE100 performed relatively well due to its number of large cap, defensive stocks declining by only 2.9%. While the FTSE100 posted this moderate decline, the FTSE 250 posted a decline of 20.5%, the CAC -17.2%, and the DAX -19.5%.

I have purposely focused on world macro events because the primary driver of the portfolio decline over the past six months has been compression of the PE multiple on the back of these expectations of inflationary and interest rate increases and not a decline in business metrics. It is important to note that the idiosyncratic portion of the portfolio return - that return of the portfolio that is related to the underlying operations of the companies that we invest in - has been positive and growing through time.

We expect that these fundamental drivers of return will continue to be positive despite the factor headwinds remaining for a while. What this means is that we have an opportunity now to allocate capital to businesses which are growing strongly and whose share prices are trading at significantly cheaper prices than their valuations suggest they should be. Once we see these headwinds ease up, we expect that there will be a significant unlocking of value throughout the portfolio.

After a substantial improvement in the second half of last year, the UK market was down by 9.88% in the first quarter of this financial year as can be seen from the table below.  By comparison, our portfolio underperformed even after making an adjustment for the 3.9p dividend in March, but did outperform in the second quarter with the NAV down by 11.44% as compared to the FTSE250 which declined by 11.78%.

As reflected in the Financial Statements, dividend revenue in the current financial year increased by 24.3% as compared to same period last year which is a welcome sign of business conditions continuing to normalise.  As detailed elsewhere in this report, mergers, acquisitions and our assessment of underlying business resilience has resulted in a further reduction in the number of stocks in the portfolio to the current holding of 24 stocks with the intention of using the proceeds to acquire a few new names as soon as market volatility wanes.   Consequently, the Company realised capital profits before expenses arising from the sale of investments during the period in the amount of £304,722 (30 June 2021: £149,653).

The continued increase in the dividend income that we receive from our investments, as well as the current level of retained earnings and realised capital reserves, should provide shareholders comfort that even in the current environment when share prices are under pressure, we are in the enviable position of being able to continue to pay dividends to our loyal shareholders for the foreseeable future.

As this market uncertainty continues, it is more important than ever that one has a strict investment process. It is vital not to get caught up in the hype and noise of the daily market movements, and instead invest with a long-term approach. A sound investment philosophy sets out a number of 'rules' or 'procedures' that we fall back on when the market noise gets too loud.  Companies that have a sustainable competitive advantage will always be well-placed to withstand short-term headwinds, regardless of market conditions, maintain market share and ultimately find new ways to grow.

It can be challenging to recognise the potential in companies, particularly those that are in the growth stage of their life cycle. It can also be difficult to evaluate the 'narratives' that some companies are telling about themselves.  To invest in a company in the growth stage of their life cycle it is important to balance the company's narrative alongside its numbers.

By drilling down into a company's financials and growth plans in a careful, considered and committed way, it is possible to identify the quality growth stocks that will prosper over the long-term. Their ability to be flexible, to move quickly to take advantage of opportunities as they arise, and to capitalise on market trends and demand, will continue to support the ongoing success of such businesses and provide significant long-term opportunities for their investors.

Sustainable Investing

Athelney Trust Plc is committed to responsible investment and we believe that Environmental, Social and Governance (ESG) factors have a material impact on long-term investment outcomes. The consideration of ESG factors is an integral part of our decision-making process and is fully integrated through asset selection and portfolio management procedures. ESG issues are central to understanding and framing the contextual, systematic and idiosyncratic elements of the business and to this end we have adopted a Quality Franchise framework comprising six distinct pillars into our research process.  This framework ensures that companies are analysed in a systematic way to ensure they are sustainable over the long-terms as well as able to improve shareholder returns. Furthermore, through the application of this six-pillar framework, our investment process aims to mitigate our portfolio against ESG and sustainability risks through placing a material emphasis on Sustainability and Management by being two of the six distinct pillars:

• The sustainability pillar focuses on areas of a business where there may be risk to the predictability of business operations through time. This assists our mitigation of default risk and uncertainty of business expansion.

• The management pillar focuses on the trustworthiness of management. This assists our mitigation of uncertainty by reducing the risk of managerial conduct or failure of business strategy execution.

The other pillars are the Industry, the Business, the Competition and the Financials.

Our investment philosophy and corporate values steer us away from companies that have the potential to harm society, and moreover, help us avoid companies where there is a risk to the sustainability of their business operations. It is also important to note that we also exclude a number of industries including weapons, tobacco, gambling, thermal coal, petroleum, old-forest logging, palm oil, and pesticides - a list that is reviewed annually.

Investment Philosophy

As far as portfolio investments are concerned, our investment philosophy is clear:

I.       The economics of a business drives long-term investment returns; and

II.      Investing in high quality, growth businesses' that have the ability to generate predictable, above-average economic returns will produce superior investment performance over the long-term.

In essence, this means that in assessing potential investments we:

a)      Value long-term potential, not just performance

b)      Choose sustainable, growing businesses; and

c)      Ignore temporary market turbulence

The key attributes that will define our investments are:

(1)    Organic Sales Growth: Quality franchises organically growing sales above GDP growth that can do so (sustainably) because they have a large, growing market opportunity and compelling competitive advantage which will drive ongoing market share gains are attractive.

(2)    A Proven Track Record: This encompasses both the management's capability and the strength of the business' model. Generally, a firm that consistently delivers a Return on Equity of greater than 15% indicates a Quality Franchise for us.  Our investment philosophy is built on the belief that a stock's long-term return to shareholders is driven by the return on capital of the underlying business.

(3)    Company's future profits: In essence we are backing a proven management team and a successful business model. Management are the key decision makers regarding the company's strategy and its competitive position in the marketplace and it is critical that we have confidence in the company's ability to sustainably execute its strategy and grow their earnings, even in a tough environment like the current Covid-19 and Brexit conundrum.

(4)    Low Leverage: We require investments to operate with low levels of debt, which ensure that they have sufficient resources to execute on their strategy. An Interest Coverage above 4x provides sufficient bandwidth in times of economic trouble. As a long-term investor, capital preservation is the highest priority. There is nothing that changes a management team's focus toward the short term quicker than impending debt refinancing when market conditions suddenly change for the worse. We need to be comfortable that this will not happen and that the company has a strong enough balance sheet so that it will retain optionality and can quickly and efficiently execute its strategy over the long-term.

Dr Manny Pohl AM

Managing Director

26 July 2022

4.   Net Asset Value per share is calculated by dividing the net assets by the weighted average number of shares in issue 2,157,881.

5.   Financial Instruments

       Fair value hierarchy

The fair value hierarchy consists of the following three classifications:

Classification A - Quoted prices in active markets for identical assets or liabilities. Quoted in an active market in this context means quoted prices are readily and regularly available and those prices represent actual and regularly occurring market transactions on an arm's length basis.

Classification B - The price of a recent transaction for an identical asset, where quoted prices are unavailable. The price of a recent transaction for an identical asset provides evidence of fair value as long as there has not been a significant change in economic circumstances or a significant lapse of time since the transaction took place. If it can be demonstrated that the last transaction price is not a good estimate of fair value (e.g. because it reflects the amount that an entity would receive or pay in a forced transaction, involuntary liquidation or distress sale), that price is adjusted.

Classification C - Inputs for the asset or liability that are based on observable market data and unobservable market data, to estimate what the transaction price would have been on the measurement data in an arm's length exchange motivated by normal business considerations.

The Company only holds classification A investments (2021: classification A investments only).

6. Related Party Transactions

Dr. E. C. Pohl is the sole beneficial owner of E C Pohl & Co Pty Limited and a Director of Astuce Group.  E C Pohl & Co Pty Limited held 86,000 (2021: 496,000) shares and Astuce Group held 550,000 (2021: 140,000) shares in the Company as at 30 June 2022.

Copies of the Half Yearly Financial Statements for the six months ended 30 June 2022 will be available on the Company's website www.athelneytrust.co.uk as soon as practicable.