HL Select UK Growth Shares - Q1 2023 Review

James Jamieson - Fund Manager

9 May 2023

The first three months of 2023 posted another positive result, with UK Equities up 3.1% to 31 March. However, the direction of travel over the quarter was by no means a straight line. January and February were characterised by a continuation of the trends seen late last year, with a 'dash for trash,' for want of a better expression. Then, the mini financial crisis erupted in March which prompted markets to adopt a more defensive stance.

From our HL Select perspective, the problems faced by Silicon Valley Bank and the other regional/specialist lenders in the US are specific to them. The same can be said of Credit Suisse, although their woes potentially have far greater systemic implications. We are confident that major UK banks are relatively well capitalised. However, these events nonetheless serve as an important reminder of the painful consequences that tighter monetary policy can bring. More on this in the Outlook.

Hard macroeconomic data is still coming through better than expected, with demand having remained remarkably resilient. This was the case on both the industrial and consumer fronts, which explains why capital goods have led the industrials' outperformance over the ­­period, as well as the relative strength of the consumer discretionary sector. In contrast, miners were the weakest sector, with their cyclical nature counting against them as recession worries mounted.

A relatively mild winter helped keep gas prices lower than had seemed likely, easing inflationary pressure, which also helped sustain demand. But inflation remains in double digits, and central banks have continued to raise interest rates and reassert their commitment to continue doing so. These actions will inevitably cause economic pain, but inflation is considered the greater evil. Indeed, inflation remains the main topic determining asset prices, and the market seems totally disinterested by the ongoing conflicts and trade disputes. Concerns to highlight include Russia building out nuclear infrastructure in Belarus and China's more hawkish post-COVID foreign policy.

Fund Review

The portfolio returned 1.3%* in the quarter, with our high quality causing the fund to lag in the early, more buoyant months, then reclaiming ground as investors became more cautious in the wake of the US bank failures. High interest rates present headwinds for the sorts of growth companies that we like because their valuations are especially sensitive to a higher cost of capital.

When looking at sector contributions, the main standouts are broadly similar to the benchmark. Industrials came out top, specifically due to Commercial and Professional services, which did well thanks to the market beginning to re-appreciate the resilient growth on offer from two of our big positions: RELX and Rentokil (see Stocks Review below). Consumer Discretionary was also strong as per the index, while Materials were a detractor, although significantly less so than the overall market. A point of difference is Consumer Staples, which dragged for us, largely due to one stock that is discussed in the next section.

Total Return (%): Fund v Index v Peers

Past performance is not a guide to the future. Source: *Morningstar Direct to 31/03/23

Stocks Review

Winners

RELX is, we feel, an excellent company that has continued to execute on their strategy. The key appeal has been dependability and they have delivered stable growth and returns, but for some time we have been observing an acceleration in the Risk and Legal divisions, alongside a post COVID recovery in Events. This recovery came through in February’s full year results. RELX offers investors a progressive dividend policy, backed by attractive growth and the return of additional capital to shareholders by means of a new share buyback. Earnings forecasts were upgraded, helping the stock to perform well in the quarter.

Auto Trader sold off in December before it rallied hard in the new year, with no particular reason to explain this behavior. As with some of the other names in the fund, the shares benefited in March from their quality growth hallmarks, with this profile of stock well bid during the recent Banks turmoil which raised fears of an economic slowdown.

Rentokil’s performance can basically be explained in the same way as RELX: a beneficiary of re-rating alongside a strong full year report. For the first time the numbers put out fully reflect the Terminix acquisition that they completed in the US last year and importantly, contained both encouraging disclosures and increased synergy guidance. So, digestion of the asset has been going well, the thesis of the deal is being justified and the potential value on offer looks more likely to be delivered. Hopefully this will continue. Elsewhere in the business, operational momentum remained strong.

Next is in the top table again. The share price this quarter was a function of the surprisingly robust consumer data that has continued to come through in the UK, rather than any developments specific to the company. We won’t evangelize their merits this time around although it’s worth noting that its recent trading statement highlighted a more challenging outlook, which we struggle to disagree with.

London Stock Exchange (LSE), like Auto Trader, had a tough December through the risk-on bounce and has since benefitted from a reassertion of the quality growth style. Like Rentokil they produced a solid update, with LSE’s forecast synergies from the Refinitiv deal edging higher. Furthermore a large placing of stock from Blackstone was very well supported, in turn underpinning the investment case and removing concerns that ongoing sales from Refinitiv’s former private equity owners will act as an overhang.

Past performance is not a guide to the future. Source: Bloomberg (01/01/23 – 31/03/23)

Losers

British American Tobacco was partially afflicted by poor performance among Consumer Staples, but various company-specific negatives weighed on the shares. Recall that while the legacy business produces very strong profitability and cashflows, it is the next generation products that serve as a driver of perceived future value and are important to investor sentiment. So, the weakness is no surprise given negative rulings on both legal and regulatory issues concerning their vaping franchise, alongside a loss of share in the key US combustibles market. The company has chosen to prioritise paying down debts over and above buying back stock. While we think this is the right thing to do in the current climate, the announcement disappointed investors and removed a support. The operational delivery has been unsatisfactory and we are appraising how persistent these changes might be.

Lancashire had an exceptionally strong Q4 and as is so often the case in these quarterly updates during volatile markets, the stock has moved from one camp to the other. The full year company update was very satisfactory and the outlook comments chimed with our core thesis which is centered on strong renewals from demand and hardening prices due to the scarcity of capital offering insurance. The market cap is smaller than our average holding and the higher risk profile means that the share price moves around more. We continue to see fundamental value.

Close Brothers has incurred a perfect storm across its three divisions. The trading business has been impacted by low volumes, an issue beyond their control. The wealth management business has incurred poor performance, this periodically happens. It is the underperformance of the banking business that exercises us given Close Bros.’ high-quality, counter-cyclical model is the main appeal to own the company. In summary, they acquired a non-core specialist lender called Novitas a few years ago, that has been written down after its lending decisions were found to be poor. While there could be writebacks, the events raise questions about operational management and capital allocation decisions. Our work suggests that the incident is isolated, but we continue to review closely.

Experian has little in the way of obvious reasons for the quarter’s performance. Our work suggests they are seeing stronger competition in some parts of the US business, so perhaps other investors are responding to the same findings. An update early in the quarter was very much in line with expectations.

Croda is a new position. As mentioned above, the Materials Sector has been very weak in response to a worsening outlook for the cycle. We lent into this weakness to establish a position.

Past performance is not a guide to the future. Source: Bloomberg (01/01/23 – 31/03/23)

The Outlook

As conveyed at the last update, we anticipate low visibility and elevated volatility in 2023, and this view remains. Trading activity in the portfolio has been focused on building out diversification in under exposed areas. The addition of HSBC, Croda and Ashtead all speak to this and have a common theme – pro-cyclical businesses that have embedded resilience. The individual rationales on each can be found on the website. Ascential was the only exit, with reappraisal concluding that the valuation is uncompelling given what we see as an increasing vulnerability to competition.

The mini financial crisis that saw bank failures in the US and the forced acquisition of Credit Suisse by UBS was the big story of the past period. As touched on in the Market Review, the events are an important reminder of what happens under a tighter monetary regime. So from our perspective these forces are unlikely to be contained to the first quarter, not least because we see banks being more reluctant to lend. Precisely how and when these forces present in the future we do not know, although the hit to sentiment can only exacerbate those tighter credit conditions and ultimately accelerate the downturn to come. In other words, the starting gun has been fired.

Central Banks are now between a rock and a very hard place. Inflation remains persistent but the travails of the banking sector means that the growth outlook appears increasingly challenged. The big question is now whether these policy makers remain true to their pledges and enact further tightening, even when economic prosperity visibly worsens. Equity markets seem likely to remain rather unpredictable until a clearer view of the growth outlook, good or bad, is established.

With investors more alert to the potential for pain ahead, Q1‘23 corporate results and especially the outlook statements from management are likely to set the tone for markets in the current quarter.