2020 first quarter review

Charlie Huggins (CFA) - Fund Manager

20 April 2020

Coronavirus and markets

The human consequences of coronavirus are tragic, the economic damages traumatic. Our thoughts are with all those affected by this devastating outbreak.

The impact of coronavirus on economies is devastating because the efforts necessary to control the disease require the cessation of a vast swathe of economic activities. It is much easier to shed revenues than it is to cut costs, so many companies are finding profits sharply cut, or even swinging into losses.

Unemployment is rising at a pace we hoped would never be seen and despite massive offers of government assistance, the sad fact is that it will come too little, too late for many. Folding firms and furloughed workers, not to mention the now self-unemployed, will surely generate bad debts in the months to come.

In short, we are in an unprecedented economic slowdown, the nature of which we have not known before. In the war, the domestic economy could carry on, indeed it was imperative that it should. Coronavirus however blocks the nation’s economic arteries long before it takes its health toll at scale. Europe is largely in lockdown, much of North America likewise. Political responses have ranged from dynamic and determined to President Trump’s. It seems likely that restrictions will be with us for some time.

Market impacts have been severe. Travel and hospitality stocks were obvious victims, and as demand for travel fell and industrial demand waned, energy prices tumbled. Oil prices, above $60  per barrel in early January have been flirting with $20 in recent days.

In the space of a few short weeks the world up-ended. Investors sought the haven of the US$ and the value of sterling tumbled to multi-decade lows. High quality bond prices surged, whilst junk tumbled as investors focused on the likelihood of repayment rather than the yield on offer.

Stock markets around the world have fallen sharply. At home, the total return from the FTSE All Share Index for the quarter was -25%, whilst Wall Street tumbled 20 %*. Industries worst affected, like Aerospace, pleaded for bailouts, whilst supermarket CEO’s practiced their straight faces as they counted the monies thrown at them by panic-buying shoppers.

The timing of recovery will be influenced by the progress made in the fight against coronavirus. What is clear is that huge expenses will have been incurred and debts accumulated, both public and private. So far the HL Select philosophy of focusing on businesses that have strong balance sheets and dependable revenues has provided some shelter from the worst of the storm. We believe this same approach will help the funds to navigate what is likely to be a recovery quite different in nature from a typical cyclical bounce.

HL Select UK Growth Shares Fund.

During the quarter the fund suffered a decline in value of -19%, which was a little better than the wider market, which saw a total return of -25%. You can see the fund’s returns over the periods since launch in the table below.

Past performance isn’t a guide to the future. Source: Lipper IM 31/03/2020.

N/A = performance for this time period is not available.

Best Performers

Past performance is not a guide to the future. Source*: Bloomberg (31/12/2019 – 31/03/2020)

The above holdings have held up very well in the context of the UK stock market’s 25% decline*. The return from our US holdings, Adobe and Visa, further benefited from a c. 6% strengthening of the US Dollar against the pound.

While none of these businesses are immune from Coronavirus (with the possible exception of Sabre Insurance), we expect them to be much more resilient than most.

Whether people are driving their car or not, they still need to insure it. In addition, fewer cars on the road means fewer motor accidents. This should leave Sabre, a little known specialist motor insurer, well positioned providing it can navigate the operational impacts from the virus. Sabre is now one of our largest positions in the fund, at a c. 5% weighting.

The five other companies derive a high proportion of repeat and recurring revenue from subscriptions and/or transactions of essential goods and services. For example, a significant proportion of Relx’s revenue comes from providing academic researchers with subscriptions to journals. These are long term contracts paid by libraries providing great security of income for Relx.

Sanne administers alternative funds. These funds are closed ended (meaning investors cannot make withdrawals), have long lives and the bulk of Sanne’s fees are not dependent on asset values. With all of the work capable of being done remotely, the business is also well set up from an operational perspective to navigate this crisis.

Worst performers

Past performance is not a guide to the future. Source*: Bloomberg (31/12/2019 – 31/03/2020)

The significant decline in the oil price to below $30  per barrel led to large declines in our oil-related names, Shell and Rotork. Our worst performer, Rotork, was a small position in the fund (1.6% average weight) and has been exited. This is discussed in the next section.

Medica, the teleradiology specialist, was also a very small position (0.77%  average weight). We expect the company to be impacted by a decline in A&E submissions for non-COVID-19 conditions as people self-isolate. We also expect interpretation of non-essential scans to be put on hold. However, we retain a small position as the company has a very strong balance sheet and is well-placed to benefit from the recovery when it comes.

Berkeley Homes, in common with other housebuilders, has seen its share price hit hard. Many of its construction sites are now closed and hardly anyone will be buying a house in the current environment. It’s also likely that house prices will see some weakness in response to the economic fall-out from the virus. However, none of this changes our long term outlook for the business. Berkeley has the strongest balance sheet in the sector with around £1bn of  net cash so is exceptionally well placed to navigate this crisis and emerge stronger.

Ascential own a mixture of digital businesses and events that bring professionals together. Their largest gathering is the Cannes Lions festival, where the creative industries meet to mingle and award Lions to the agencies deemed to have made the most impactful campaigns. It’s a huge affair and has now been cancelled for the year. The financial impact will be sharp, but Ascential have a strong balance sheet to get through this. Their portfolio remains a compelling collection of unique businesses well positioned to thrive in the digital era.

With schools, offices and sports venues shut, Compass, the contract caterer, has seen revenues from a large part of its business evaporate and is now incurring losses. We are prepared to ride out this period because we feel the company is the strongest operator in the sector and should emerge from this stronger than rivals.

Portfolio changes

The outlook for businesses has changed significantly over the last six weeks. We are still happy with the vast majority of businesses we own, but inevitably some will be more impacted than others. We’ve tried to position the portfolio as best we can for this new reality, which means our trader, Lennie, has been much busier than normal.

We’ve sold our holding in LVMH, the luxury operator. The shares had held up surprisingly well but we expect sales to come under significant pressure over the coming months, with the majority of luxury stores closed. LVMH also has more debt now following its 15 billion euro purchase of Tiffany and while it has very solid credit ratings; that could change the longer this situation persists.

We’ve also exited our small position in Rotork, the flow control specialist which is heavily exposed to oil and gas markets. The steep decline in the oil price to less than $30 per barrel means we expect capital expenditure from oil and gas companies to come under significant pressure as they seek to protect their cash flows.

Elsewhere, we’ve significantly reduced our positions in Rightmove and Auto Trader from around 4.5% to c. 2.6% each. Both are wonderful businesses but their customers are under enormous pressure, as people cannot buy cars or houses when they are self-isolating. Both companies have taken swift actions to support their customers and will incur losses while this situation persists. We’ve also seen Auto Trader announce a 5% share placing to strengthen its balance sheet. Both businesses are well placed to emerge stronger from this which is why we’ve retained exposure, but near to medium term trading is likely to remain very challenging.

We’ve also reduced our position in Intertek as we expect Coronavirus to have a significant impact on global trade and supply chains, which doesn’t bode well for its business. We have also trimmed back Ideagen and GB Group; both of which have held up well so far and had grown to occupy higher weightings than we wanted.

We have used some of these sales proceeds to increase our exposure to Relx, Unilever, Diageo and Visa. We expect the defensive qualities of Relx, with its high proportion of subscription revenue, and Unilever with its diverse portfolio of largely essential goods (like food and shampoo) to shine through in the current environment (although note Relx has some exposure to events and exhibitions which will be severely impacted).

Diageo and Visa will, we suspect, see a big negative impact from Cornonavirus in some parts of their businesses, but other parts should remain resilient. Diageo will see a major decline in sales to pubs, bars and restaurants but sales through supermarkets and convenience channels should hold up much better. Visa’s travel-related revenue streams will see a significant impact from this period of lockdown, but we believe the current situation is likely to accelerate the trend towards digital and card payments.

We’ve also made modest additions to Sabre Insurance, the specialist motor insurer, which if anything could benefit from fewer accidents on the roads; as well as Shell which we deem to be strong enough to withstand this period of lower oil prices.

Please note the author and/or his connected parties own shares in Sanne Group and Ascential.