Areas we are avoiding, plus five new holdings

Charlie Huggins (CFA) - Fund Manager

16 March 2017

Most of our positions are now built, with at least a 2.5% weight in all our chosen names. There is some fine tuning to be done, but we are ready to reveal five more stocks in the fund, details below.

In Steve’s last blog, he talked about how some of the names in the fund fitted in with our investing philosophy. Sometimes, fund management is as much about what you don’t hold as what you do, so in this post I’m going to talk about how our philosophy leads us to avoid certain areas, and why.

Areas we have avoided

If a dividend can’t grow, there is an elevated risk that it might be cut. Cuts are most likely when cash flow comes under pressure at companies that are already struggling with debts, and paying out much of their earnings to shareholders.

That means careful navigation around the natural resources sectors, for weak commodity prices have devastated producers’ incomes and already led the major mining companies to cut their payouts. BP and Shell have gone to great efforts to maintain their dividends, but oil prices are still a fraction of what they were, and seemingly under renewed pressure.

There may come a time when commodity producers manage to get their costs down to a level where cash generation will be robust, but for now, we’d rather not take the risk of their dividends proving unsustainable.

We have no exposure to mobile or fixed line telecoms. Vodafone, a traditional income favourite, has struggled to generate enough free cash flow to cover the dividend in recent years. The sector is also highly competitive so has very little pricing power.

With the exception of Lloyds, major banks are also absent from the portfolio. Lloyds is a simpler, leaner bank nowadays, but the other major players in the industry still have much more restructuring to do. We would rather own specialist financial services players, such as Close Brothers and Provident Financial, which are both highly profitable.

The other notable absentees are housebuilders. Although yields are currently high, they are predicated on housing market conditions remaining favourable. Traditional retailers are another area where we have zero exposure, because we worry that the shift to e-commerce will lead to further pressure on sales and profits.

In general we seek businesses that we believe can reliably pay increasing dividends years out into the future. We focus on companies' financial strength, their ability to generate cash and their prospects for profit growth. This may mean we avoid certain areas, but we believe this approach will be rewarded in the longer term. Please note dividends are variable and not guaranteed.

New holdings

We have five new holdings to reveal. Two of these are also held in the HL Select UK Shares Fund – car auction house, BCA Marketplace, and events-specialist, Ascential. Both offer their customers vital services and we believe they have exciting growth prospects.

The other three fall into the dividend stalwart category, offering yields in excess of 4% (not a reliable indicator of future income). Tritax Big Box REIT owns large ‘Big Box’ distribution centres which it rents on very long leases to a range of tenants. Supply is limited and demand is underpinned by the rapid growth of e-commerce, which is supporting solid rental growth.

Primary Health Properties is another Real Estate Investment Trust that owns a portfolio of modern primary healthcare premises. Like Tritax, PHP benefits from very long leases, and the majority of rental income is government-backed, providing a highly secure income stream.

The fifth new holding is Paypoint, which provides a range of basic payments services, like pre-pay meter top-ups or housing association rents through a network of 40,000 convenience sites. The business model is highly cash generative, supporting a prospective yield of c. 8%, including ordinary and special dividends.

We have now revealed 25 out of 27 holdings. You can find out more about all of these companies by clicking the "More details" button next to their name on the Portfolio Breakdown page. We hope to reveal our final two holdings in the weeks ahead.

Charles Huggins owns shares in Ascential, Tritax Big Box and Paypoint in his personal account.

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