First quarter review 2020

Steve Clayton - Fund Manager

17 April 2020

Coronavirus and markets

The human consequences of coronavirus have been 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 the author 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 CEOs 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 Income Shares Fund

During the quarter the fund suffered a decline in value of -21%, which was a little better than the wider market, which saw a total return of minus 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 market was firmly focused on seeking relative safety. Pennon Group owns South West Water and Viridor, the recycling and energy-from-waste group. There is little more defensive than water supply and during the quarter Pennon announced the sale of Viridor for £4.2bn. Primary Health properties owns doctors surgeries in the UK and Eire, with the rents paid by government agencies and has seen little if any impact upon its finances from the virus pandemic.

National Grid is another highly defensive business, distributing energy in the UK and USA, an activity likely to continue under all circumstances. AstraZeneca’s new drugs are growing rapidly as it makes strides in the field of oncology, whilst Unilever’s raft of personal products, foods and household items are used by people day in, day out.

Worst Performers

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

Just as the stronger performers were those names where the market saw least risk to earnings, the weakest were those with the greatest perceived risk.

It is clear that the global economy is shrinking at an unprecedented rate. That is not a good environment for banking profitability. Even with Government support packages available, we are likely to see significant rises in bad debts. We quizzed Lloyds about their expectations  and were surprised to learn that they see relatively modest exposure to bad debts, even in a severely stressed economy. The market clearly shares our scepticism and Lloyds and other banks were hit hard this quarter.

Paypoint announced that a proposed utility payments holiday could impact their earnings and the market reacted sharply. Having spoken with the company, we feel that the market reaction is at odds with the degree of impact that is actually likely to be felt by this relatively defensive business and we have added to our holdings.

The collapse in the oil price is of almost unprecedented magnitude in such a short period of time. Demand for oil has fallen sharply and it would be foolish to expect oil company earnings not to be sharply impacted. Nonetheless Shell has more strings to its bow than simply producing oil and its earnings from refining and marketing fuels and lubricants, manufacturing and shipping LNG to utility customers and chemicals production will provide some protection. The company has raised billions of dollars of liquidity and reduced capital expenditure plans, suggesting it intends to continue distributions to shareholders.

Persimmon's world has been up-ended by the virus. Building sites have come to a halt and sales of houses put on hold. The company’s net cash position  will allow it to “hibernate” for some time, but they have announced a cessation of capital returns and dividends for the foreseeable future.

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.

How we have managed the fund 

Our focus has been on raising the defensiveness of the portfolio once it became clear that the outlook was fast shifting. We increased exposure to GlaxoSmithkline and Unilever, along with Tritax Big Box; the latter expected to benefit from the long leases on which it lets its assets to tenants. We took advantage of strength in Primary Health Properties early in the quarter and trimmed our position, then reinvested back into it once the price came back with the market in March.

We reduced our exposure to Financials by trimming our position in HSBC and exiting completely from the Standard Life Aberdeen position where we were becoming concerned about the sustainability of the dividend, even before the coronavirus outbreak.

We added to Royal Dutch Shell in early March after its stock hit levels that we felt overstated the risks. We also initiated a position in Persimmon in early February that reflected what at the time looked like a promising housing market. With hindsight, a different decision would have been better, but our choice of Persimmon over other operators was driven by its financial strength and its competitive position is likely to be improved once this crisis has passed.

We trimmed our holding in GB Group after substantial outperformance of the wider market, but retain a meaningful holding.

The outlook for dividends

This situation is fast evolving, but it is clear that the level of dividends paid out by companies will be sharply reduced in 2020 compared to the year before. The Prudential Regulatory Authority has instructed banks not to pay dividends, to boost their ability to absorb bad debts. European regulators are reportedly suggesting that insurers should likewise scrap their payouts to shareholders.

Industrial companies are cancelling payments at pace. Even ones that have gone ex-dividend but not yet paid. This is pretty unprecedented in the author’s thirty three year market career. Governments are making cancellation of dividends a quid pro quo for their support of the economy. Equities have always been risk investments and dividends are variable and not guaranteed. But despite those familiar caveats, the current situation is unprecedented in terms of the proportion of companies being impacted at the same time and the scale of accompanying dividend reductions.

Your fund is not immune and the income it will receive in the second half of the financial year will be substantially lower than the amount received in the first half, when historically we would have expected more than half of the annual income to be earned in the second half.

If there is positive news to be found in all of this, it is that the valuations of quality businesses with good longer term dividend potential are cheaper now than for many years. Clearly there are many hurdles, obstacles and mantraps to be navigated around in the months ahead. We will not pretend to know how many months of navigation are required before we get to calmer waters, but get there we will. 

You can see every holding in the portfolio and find out why it was chosen, on the portfolio breakdown page.

Unless otherwise stated, all performance data is sourced from Bloomberg and refers to the period 1st January 2020 to 31st March 2020.