January review

Charlie Huggins (CFA) - Fund Manager

3 February 2017

The UK stock market started January brightly, building on December’s gains, but finished broadly flat, as a degree of scepticism towards President Trump’s America First policies emerged. The fund has continued to see good inflows, allowing us to keep building some of our favoured positions.

Full year results season underway

The full year results season got underway in earnest this month. Our strict focus on quality meant we avoided a number of bullets; with Pearson, Next, Restaurant Group, BT, Mitie, Premier Foods, Essentra, Cobham and Foxtons (amongst others), all issuing profit warnings.

The reasons for these warnings were varied, but we can pick out a couple of themes. The first is aggressive or improper accounting. BT’s Italian operations fall firmly into the latter category ; Mitie and Cobham arguably the former. This is why we focus so much on cash flow. Cash is real and can’t easily be fudged. Profit is a number made up by accountants and is very sensitive to the assumptions used.

BT and Mitie’s woes can also be blamed on government funding pressures, with the former offering up a very gloomy prognosis for its public sector division. Thankfully, none of our holdings have meaningful exposure to the UK public purse.

Positive contributors

The biggest contributors to the fund in January are shown below, along with their total return for the month.

Past performance is not a guide to future returns. Correct as at 31/01/2017

Burford Capital had another excellent month. At the start of January Burford announced it had sold a part-interest in a law suit that values the case at around $180m. The case could eventually be worth up to $1.5 billion to Burford, if the final verdict goes their way. It might not conclude successfully, so analysts aren’t including it in their estimates. But it’s one of those situations where the upside looks to be much greater than the downside to us, so we view it as a positive development.

Burberry and Diageo both issued results this month, with the former reporting a return to growth in Asia; and the latter reporting a pick-up in sales across the board. Meanwhile, British American Tobacco finally completed the $49bn acquisition of Reynolds American. We were surprised to see the shares fall following the announcement, and took the opportunity to add to our holding. Since then they have enjoyed a nice rally.

BATS already owned almost 40% of Reynolds so it knows the company well (always reassuring for a deal of this size). The US is an attractive market because cigarettes there are amongst the most affordable in the world, and new generation products, like Vaping and Heat not Burn are creating new opportunities for growth. We think this deal boosts BATS’ earnings prospects and raises the scope for further dividend growth. The main negative is the increase in net debt, but BATS has always generated a lot of cash, so ought to be able to deleverage quickly.

Biggest negative contributors

Past performance is not a guide to future returns. Correct as at 31/01/2017

Sage and Unilever (our 7th biggest negative contributor) both reported results this month which came in modestly below analysts’ expectations. The shares ended the day around 5% lower. Steve talked about these results in his previous blog. We continue to like the long term prospects for both businesses and added further to our positions.

Earlier in the month, Just Eat issued a very brief trading update. Full year orders rose by 36% on a like-for-like basis, and the group gave a confident outlook for 2017. The shares promptly fell by around 6%.

Just Eat had enjoyed a strong run up to that point and didn’t say anything new to encourage more buying. So investors chose to take profits. We took the opposite view and added to our position. Although a forward P/E (share price divided by earnings per share) of around 32x may seem high, analysts are forecasting earnings growth of around 250% over the next three years. If the company can get close to that, we think we will be rewarded.

Summary

The numerous profit warnings this month suggest that many companies are finding life tough, with a number of end-markets under pressure. But reassuringly, results from the fund’s holdings in January have been broadly in line with our expectations, and we either maintained or increased our positions.

The next month sees an important period for the fund with more than a third of our holdings due to report results. As these are released, we will issue status updates on the main blog page giving our initial reaction to the numbers, with more detailed updates to follow over the next few weeks. In the meantime, we thank you for your on-going support.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts from Bloomberg. They are not a reliable indicator of future performance. Yields are variable and not guaranteed. The HL Select UK Shares Fund is managed by our sister company HL Fund Managers Ltd.