HL Select Funds: special report

HL Select - How we’ve navigated choppy waters

We set up HL Select a little over three years ago. Our aim was to offer HL’s clients a new style of fund.

HL Select funds would be focused on high quality stocks, aiming for predictable growth. Although a higher-risk approach, the concentrated portfolios would mean each holding could make a real impact on performance. We believe investors have the right to know how their money is being managed. So we decided to show our portfolios online, and to write regular blogs explaining what we were doing with the funds.

In just a few short years, the world has changed in ways that we could not have imagined. When we launched, Brexit was hogging the headlines; were it not for Covid-19, it still might be.

The UK market as a whole has lagged international indices by some margin since the referendum, but this only tells half the story. UK companies dependent on the domestic market have lagged their more internationally focused peers by some margin. Much of this is no doubt due to a weak pound, and lower expectations for UK growth, but we see other factors at work too.

Many of the more domestically exposed sectors, such as retailers, are also badly placed in the digital economy. We would argue that whatever questions Brexit may have posed for the UK High Street, Amazon and Asos posed more.

Digital transformation

We see the digital transformation of economies around the world accelerating. The roll-out of 5G mobile networks is only just kicking off. The jump in connectivity enabled by 5G will be a step change, like the move from dial-up modems to broadband. Companies that seize the opportunity to manage vast quantities of data at lightning speed will be able to produce cheaper and faster, understand their clients better and market to them more precisely.

That’s why we always try to identify which players in any industry look like the digital winners. We don’t believe that a technology revolution means that you should only hold tech companies. Far from it; such a strategy would be risky due to its concentration on a single sector. But backing the businesses that are using technology to reshape their own markets allows us to gain from technological progress whilst spreading risks.

The impact of the virus

The other transforming factor that markets have had to cope with of late, has of course been Covid-19. We’ve seen other viruses break out before. SARS and MERS both had similarities to Covid-19, but never the same degree of impact. Ebola did its worst to parts of Africa and China has seen terrible damage wreaked upon its Pork sector by an entirely different virulent viral outbreak.

A consequence of lockdown was a savage cut to the levels of dividends paid. The FT recently reported that 445 listed UK companies cut, suspended or cancelled their dividend payments, including half of FTSE100 companies and over 40% of mid-cap stocks. Some of these dividends will be reinstated over the next year or two, but some will not. Some boards will reckon that with bonds yielding next to nothing, they don’t need to pay out high dividends.

And yet, after a sharp drop as the pandemic unfolded, markets have rallied strongly. In the USA all of the drop and more has been reversed, taking Wall Street to a new market high. Interest rates have been cut to token levels here, in the Eurozone and across the Atlantic, whilst governments have flooded banking systems with liquidity. It seems cheap money is more powerful than Covid-19.

But the industries most impacted by the virus, like aviation and hospitality, are still languishing far below their previous levels. They need a return to normality, and that seems to require an effective vaccine.

Nothing lasts forever in the stock market, and there is a point where valuations of fast-growing stocks will be too rich to attract the number of new investors to be sustainable. But the disconnect between the growth of digital businesses and traditional economic models remains stark. As investors, the challenge for the HL Select team is to keep identifying digital winners where the valuation offers further upside.

How have the funds performed?

Three years in and we’re pleased with the progress so far. On the whole, both the HL Select UK funds have performed ahead of the market and their sector peers as you can see from the table below.

Past performance is not a guide to the future. Source: Lipper IM as at 31/08/20.

It hasn’t been plain sailing. The post-Covid dividend cuts were painful, and we have had to navigate through periods of intense volatility along the way.

So far though, our policy of favouring investing into businesses with high quality balance sheets and predictable growth has delivered returns ahead of the market, although please remember that past performance is no guide to the future. Investments rise and fall in value, so you could get back less than you invest.

Find out more about these funds, including charges

Key investor information - HL Select UK Growth Shares

Key investor information - HL Select UK Income Shares

Important - This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information. Unless otherwise stated performance figures are from Bloomberg and 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.

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Lessons learned and lessons taught

Three years after launching the HL Select UK funds, we’ve still got many of the stocks that we first invested into at launch. Others we have parted company with, for reasons good and bad. Here we look at a few of the more interesting and impactful businesses that we’ve invested into over the years.

When we talk about performance of stocks, we’re talking about the period for which we have held the stock up until 31 August 2020 or the point of sale if that’s sooner. This article isn’t personal advice, and the views expressed about individual companies are from our viewpoint as managers of the funds. They are not recommendations to invest. Seek advice if you’re unsure of the suitability of an investment for your circumstances.

Some of the winners

Trading costs money, so we try to make better decisions and stick to them, rather than spend money hopping from one position to another. Remember, past performance isn’t a guide to the future.

HL Select UK Income Shares made a gain of over 60% from holding Fidessa, which added 2.1% to the fund’s value. Like GB Group, Fidessa’s products, software that links financial institutions to each other, facilitating seamless processing of market trading activities, are completely embedded into customers’ core activities. This makes it very likely to be paid for again and again.

Learning from our mistakes

But not everything goes as hoped, and we’ve had bad performers too. Provident Financial fitted a lot of the criteria that the HL Select UK Income Shares fund looks for. It had a long track record of highly profitable operations, in good times and bad. Loyal customers who took repeated small loans over many years and a dominant position in its sector. But the company badly bungled a major operational change and then went on to reveal that there were tensions between it and its regulators. Instead of offering the steady yield and predictable growth we had bought it for, the shares slumped and the dividend was scrapped. The 69% loss led to a 3.1% hit to the fund’s value and left us vowing to be more alert to operational risks whenever managements introduce significant change.

For HL Select UK Growth Shares, our biggest mistake was investing into Royal Dutch Shell. Before the pandemic, Shell’s strength of cash flow had seemed irresistible. Then Covid-19 arrived and the world gave up on travelling, causing oil and gas prices to tank. The shares more than halved and for the first time in decades, Shell cut the dividend. We should have held our stance of being biased away from commodity producers. For whatever progress Shell had made controlling its cost base, it was all for nothing when a virus, wholly out of the company’s control, came along and destroyed both the demand for, and the price of, Shell’s core products. The position has cost the fund 3.5% of its value.

Somewhere in-between

In between these extremes we’ve had some interesting results. BCA Marketplace, and Merlin Entertainments both got taken over, generating good gains. Pity the poor new owners of Merlin, who will have seen Alton Towers and LEGOLANDs alike shuttered for much of their peak months.

Burberry has seen stores shuttered too. Fortunately UK Growth shares had taken its profits and sold out before the virus struck. But we’ve learned that it’s easier to sell than it is to learn how to sell well. In some instances, Playtech springs to mind; we sold on fears that the story was not quite how it first seemed and went on to watch the stock founder as problems emerged.

Likewise, we saw the competitive environment facing marketing businesses deteriorating as big digital firms like Google, Facebook and Amazon muscled in. A sale of WPP at a loss for both funds was painful, but with the shares now trading at less than half the level at which we exited, the pain was justified.

But sometimes, selling has proven premature. Greene King and Just Eat both ended up in takeovers after what we felt were solid fundamental reasons to sell. More often than not though, hanging on in hope of a takeover is an expensive hobby.

When we build the portfolios of HL Select funds, we aim to be dull. We don’t like stocks where too much hinges on an event going the right way. We prefer companies with real competitive advantages that will allow them to keep thriving, where management is focused on the future and where the finances are robust. How the market will price these businesses in the near term is anyone’s guess. But if they keep growing as we hope, their share prices are likely to rise in the longer term. Investments will rise and fall in value, so you could get back less than you invest.

Find out more about these funds, including charges

Key investor information - HL Select UK Growth Shares

Key investor information - HL Select UK Income Shares

Important - This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information. Unless otherwise stated performance figures are from Bloomberg and 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.

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Where next for quality stocks?

At HL Select we focus on quality stocks - businesses with robust market positions, strong finances, high returns and attractive growth potential. When we find businesses that fit the bill, we invest with the expectation of holding them for years to come.

In the short term, we have no idea where the market will go. Sentiment determines that. So often we see the market rise one day, only to fall the next. But in the long term businesses that keep growing will tend to increase in value.

A Digital Future

Technology has always advanced, and each major advance depends upon some new insight. We might hold the development of the internet in awe, but in truth, the invention of the plough advanced humanity a whole lot more.

Early ploughmen took existing “technologies” of oxen and wooden tools that could turn the earth, and connected them to create a more powerful way of solving the most fundamental human problem. Growing food reliably at scale, rather than foraging for it.

At HL Select we look for the ploughmen of the future. Creating completely new technologies is exciting but risky. We prefer investing in businesses that are deploying technologies, rather than inventing them.

One of HL Select UK Growth Shares largest and most successful positions has been Experian. They use data to provide banks, retailers and marketing firms with the information they need to make the right decisions about who to lend to, who to promote to and who to advertise to. It’s a business that has successfully picked up the emerging digital technologies and used them to grow their business year after year.

HL Select UK Income Shares has a large holding in Phoenix, a life assurer that acquires older life companies and boosts their profitability by transferring their operations onto a proprietary digital operations management platform. By getting their technology right, they are able to buy assets cheaply and then extract capital and cost efficiencies for years afterwards, improving service levels along the way.

It ain’t what you do, it’s the way that you do it…

A tough year for dividends

Phoenix’s business model focuses on cash generation, through thick and thin. This has allowed it to continue paying dividends throughout the pandemic. About half of the UK’s leading companies have cut, cancelled or scrapped their dividends since the pandemic broke out. Phoenix’s resilience stands out in contrast. The most recent Dividend Monitor from Link Asset Services reported UK company dividends falling by 57% in Q2 2020 with a full year outlook for falls of around 40%.

We see dividend levels recovering steadily over the next few years. The pandemic has eased substantially and the likely level of recession now looks to be less challenging than might have seemed possible a few months ago. Some companies are already talking about reinstating dividend payments, although not necessarily at the pre-pandemic level.

Companies that took cash support from Government are unlikely to reinstate their payments until they have repaid that support. Many businesses borrowed to cover near term losses and will want to reduce these liabilities before paying monies out to their investors.

So dividends across the market are likely to return at a variable pace. For the HL Select UK Income Shares fund, we think it’s likely that all bar one or two of our holdings will be paying dividends by the end of next year, the majority rather sooner than that. We reduced the fund’s monthly dividend during the pandemic and are now pleased to be able to reinstate half of that reduction for August, and we expect September’s final dividend to be a useful increase over the previous year’s level.

For the financial year to end September as a whole, we expect the Fund’s dividend to have fallen by around 12%. Next year’s level will depend in part upon the pace at which firms reinstate their payments to shareholders. Please remember that dividends are variable and not a reliable indicator of the income you’ll receive in future.

So where next for quality investing?

The range of businesses that can fit the quality tag is very broad. In our Select UK funds we have businesses as disparate as Regulatory Software creators and a property company that invests in GP Surgeries. They are united by how they go about their activities rather than by what they sell.

Valuations are higher, now that the market has clawed back a slice of its losses. But bond yields and interest rates remain close to zero. Seen from that perspective there is still much to like about businesses that are capable of delivering predictable growth. Other investment styles will have their day in the spotlight from time to time. But holding businesses that offer solid long term growth prospects never goes out of fashion as far as the HL Select team are concerned.

Find out more about these funds, including charges

Key investor information - HL Select UK Growth Shares

Key investor information - HL Select UK Income Shares

Important - This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information. Unless otherwise stated performance figures are from Bloomberg and 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.