HL SELECT UK INCOME SHARES
When UK doesn’t just mean UK
Managers' thoughts
HL SELECT UK INCOME SHARES
Managers' thoughts
Charlie Huggins (CFA) - Fund Manager
2 October 2017
Investors are understandably nervous about the UK’s economic prospects at the moment. However, it is important not to confuse the outlook for the UK economy with that of the UK stock market. The majority of UK-listed businesses generate the bulk of their profits overseas and have actually benefitted from sterling weakness following the Brexit vote.
Clearly, some companies and sectors depend more on the UK economy than others. Some, like mining and oil and gas, generate virtually none of their profits in the UK. Others, like housebuilding and general retail, are very reliant on the UK’s economic fortunes.
We have estimated the proportion of UK sales for each of our holdings and calculated a weighted average for the fund. We cannot be exact because companies do not always disclose sales by country, but we think the chart below gives a very good approximation from our analysis. As you can see, the split is fairly even.
Source: HL, correct as at 27/07/17
About a third of our holdings are very internationally focused, generating less than a fifth of their sales in the UK. About a third are largely domestic, generating over four fifths of their sales in the UK, while the remaining third sit somewhere in between. We will focus on the first and second categories.
This category includes our holdings in the consumer goods (Diageo, RB and Unilever), tobacco (BAT and Imperial), media (Relx and WPP) and pharmaceutical (GSK and AstraZeneca) sectors. All of these businesses have benefited from sterling weakness since the Brexit vote because their overseas profits are worth more once converted into sterling. Most also have significant exposure to emerging markets where rising incomes are leading to increased demand for a range of goods and services. We think this trend has many years left to run, and our holdings in this category are well placed to benefit.
A number of our domestic holdings should prove relatively immune to what is happening in the UK economy. For example, we own two Real Estate Investment Trusts - Tritax Big Box and Primary Health Properties (PHP) that generate all of their profits from the UK and Ireland.
Tritax leases distribution centres to a roster of blue chip clients, with demand strongly linked to the growth of e-commerce; while PHP owns a portfolio of specialist buildings that are leased to healthcare operators, meaning the vast majority of its income is backed by the UK government. Both companies have their customers signed up to very long leases, with upward-only rent reviews reinforcing the security of these income streams. Although, as with any investment, they can fall as well as rise in value, so investors could get back less than they invest.
In our view the utility holdings we invest in, Pennon and National Grid, should prove relatively resilient in most economic conditions. Our need for water, electricity and gas will not go away regardless of what the latest GDP figures say. Both businesses are heavily regulated and so long as they operate their businesses efficiently, the regulator should allow them to earn an adequate return from their activities.
We do own some companies whose fortunes will be more closely linked to the UK’s economic fortunes including two banking stocks, Lloyds and Close Brothers. However, we believe both are well positioned to weather any storms. Lloyds is a lot less racy these days having simplified the business, cut costs and strengthened its balance sheet; while Close Brother’s conservative approach to lending has served it well historically, enabling it to grow or maintain its dividend every year since 1999, despite the extraordinary economic events along the way.
Our exposure to the UK consumer comes mainly through pub operator, Greene King, soft-drinks manufacturer, Britvic, and Domino’s Pizza. These companies clearly aren’t immune from the UK economic backdrop, and in recent months both Greene King and Domino’s have warned of a slowdown in consumer spending.
However, they should prove more resilient than large ticket manufacturers. In tough economic times people are more likely to cut back on clothing, sofas, houses and cars than they are on a pint down the local pub, a takeaway pizza or a can of soda.
We have zero exposure to housebuilding, construction, home improvement or general retailing, which have traditionally been amongst the most susceptible to the vagaries of the economic trajectory.
The sales and profits of our holdings are well diversified across a range of sectors and geographies. A severe UK economic downturn, if it were to materialise, would be unhelpful for certain holdings, most notably in the banking and UK consumer sectors. However, these holdings account for less than 20% of the fund. The rest of our holdings are internationally diversified or provide exposure to defensive parts of the market which should prove relatively resilient in the face of economic headwinds.
Please note the author or his connected parties hold shares in AstraZeneca, GlaxoSmithKline, Tritax Big Box, British American Tobacco, Imperial Brands and Reckitt Benckiser.
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