HL Select UK Growth Shares Q2 2020 Review

Steve Clayton - Fund Manager

10 July 2020

Market Review

Hopes that the pandemic was easing led to a strong recovery in stock markets around the world. The UK was no exception, with the FTSE All Share index returning 10.2% over the quarter. Not everything went up; Energy shares and Banks were notable laggards, both sectors losing about 8%. Amongst the winners, Miners raced ahead by almost 29% and General Retailers by 28%.

Broadly speaking, what went down in Q1 saw a bounce in Q2 as it became clearer that the impacts of the pandemic were unlikely to see the worst-case scenarios unfold. Banks failed to participate however due to concerns over bad debts and a squeeze on interest margins following emergency rate cuts on both sides of the Atlantic. Energy shares were dragged lower by Shell’s momentous decision to cut its dividend and a failure of oil prices to recover to previous levels.

A notable feature of markets globally this year has been investors’ preference for “Growth” shares over “Value”. The digital economy is far more heavily represented in the former category than the latter. With untold millions working from home, communicating via video conferences over the internet and ordering their shopping online, this is perhaps understandable. But trends can only carry on if the fundamentals justify. As valuations rise, Growth stocks will need to deliver the superior earnings that investors are paying these higher prices for.

Performance Review

The fund delivered a total return of 13.3% over the quarter, compared to the FTSE All Share return of 10.2%. This was driven by our Technology share holdings, which delivered a return of 28%, adding 6% to the value of the fund. Our positions in Industrials also did well, adding almost 4% to the fund’s value. The only sector where we lost money was Energy, where our holding in Shell cost the fund 0.4% of its value.

Over the year to 30 June 2020 the fund delivered a total return of -1.1% compared to the FTSE All Share return of -13.0%.

Past performance is not a guide to future returns.

Past performance isn’t a guide to the future. Source: Lipper IM 30/06/2015 to 30/06/2020.

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

Significant Winners and Losers in Q2 2020

Winners

Past performance is not a guide to the future. Source: Bloomberg (31/03/2020 – 30/06/2020)

Our three international holdings – Autodesk, Adobe and Visa – were amongst the biggest contributors to performance this quarter. It is nice to see our strategy of adding overseas exposure vindicated through this crisis.

We are permitted to invest up 20% of the portfolio outside of the UK. We have been keen to exploit this flexibility, because it gives us access to some exceptional businesses that simply aren’t available on UK shores. Autodesk, Adobe and Visa are world leaders that dominate their fields. All three are beneficiaries of increased digitalisation.

Autodesk’s software is used across construction, engineering, manufacturing and plant design. We expect the secular trends that have been driving the business to accelerate as its customers increasingly embrace cloud-based solutions to increase the efficiency and resilience of their operations.

Adobe is the leader in Creative software and Digital Marketing. Several areas of its business have seen increased demand during the crisis. The shift to remote working for example has driven a surge in demand for digital documents, with use of web-based PDF services up nearly 40% in Q2, and cloud-based electronic signature usage increasing 175% since the start of the fiscal year. With every business likely to think harder about how they engage digitally with customers, we believe the future looks bright for Adobe.

Visa has been more impacted by the crisis so far, due to significant declines in international travel, which has impacted cross-border transactions . However, we expect this business to come back once international travel resumes. More significant in our view is the transition from cash to card and online payments, which has been meaningfully accelerated during COVID-19. We do not expect this trend to reverse once we emerge from the pandemic.

Experian enjoyed another good performance this quarter. Full year results were strong while the near term impact from COVID-19 looks manageable, and may even open up new opportunities to solve challenges from the crisis. In the mid to long term we expect the crisis to lead to an acceleration of digital trends, and increased demand for analytics and risk/fraud solutions; which should create further opportunities for growth.

Rentokil, Auto Trader, and Ascential benefitted from recoveries from a weak prior quarter. These businesses have all seen a negative impact from COVID-19, but investors have started to look past these near term headwinds. We expect the road to recovery for each of these companies to be bumpy, but believe the outlook for profits once we emerge from the pandemic remains strong.

Losers

Past performance is not a guide to the future. Source: Bloomberg (31/03/2020 – 30/06/2020)

Compass, the contract-caterer has seen perhaps the biggest impact of all our holdings from Coronavirus. With schools, universities and offices closed; and sports venues empty, it has seen revenues from a large part of its business evaporate and is now incurring losses.

On 19 May the company launched a 12% share placing to raise £2bn of cash. This strengthens the balance sheet further and should provide more than enough liquidity to allow the company to withstand a prolonged period of weaker trading. Importantly, it should also enable the company to get onto the front foot during the pandemic, ensuring they can maintain investment and capitalise on any opportunities, rather than spending years paying down debt.

We participated in this placing and added further shares in the open market after the placing to increase our position.

With the balance sheet de-risked we’ve been thinking carefully about what the recovery might look like for the sector and Compass in particular. There are some undoubted headwinds. There will likely be more working from home for example, and both the sports and education sectors will likely be slow to recover. There will also be additional costs in the recovery phase.

However, we also see clear positives for Compass. With competitors likely to retrench we expect Compass to gain share through this environment as we see it as the best placed in the sector to support its customers and exploit new business opportunities. The virus may also accelerate outsourcing trends as the costs and complexity makes many in-house offerings unviable.

Energy companies struggled in Q2 with the sector lagging the market by a large margin. Shell announced its first cut to the dividend since WW2 after the pandemic led to a slump in demand for energy and transport fuels in particular as planes stayed on the ground, cars in their garages. The economy is gradually reopening, but energy prices remain at depressed levels. Shell have announced that they will take multi-billion write-downs on the value of their assets, reflecting the lower cash flows expected in today’s lower energy price environment.

Longer term demand for energy appears robust and future prices are expected to be above current levels, with most producers forecasting longer term levels of $55 per barrel and higher. Of course, none of them forecast oil prices of $40, let alone that prices would briefly turn negative. On balance, we felt that the levels seen in Q2 understated the value within the higher quality assets we see in Shell’s portfolio and we added to our holding.

Sabre Insurance, the motor insurer, gave back a little bit of performance following a strong prior quarter, as investors started to embrace more risk. Full year results in April were broadly in-line with expectations and we don’t expect the company to be materially negatively impacted by the pandemic. That said, Sabre has sensibly decided to withhold the special dividend until greater clarity emerges; although we don’t think investors will have to wait long for this dividend to be paid (remember, dividends are variable and not guaranteed).

Outlook

Coronavirus remains a challenge and is still rampant in many nations around the world. More than likely we will see flare-ups here in the UK from time to time. But the world is moving to the stage of working out how to live with the virus, rather than trying to hide from it. This will bring real changes to how some parts of our lives are lived in future. Societies will need to protect the vulnerable until an effective vaccine or cure is widely available. We have all become much more aware of the ability of disease to turn our worlds inside out.

Companies for their part have had to wrestle with previously unimagined challenges. Ceasing trading and going into suspended animation was not part of many pubco’s business plans. But they have had to do it. So too the airlines, restaurants and retailers. Banks have seen the quality of their assets impaired, but have yet to find out by how much. Energy businesses have been reminded of the eternal truth that the best assets are the ones that have the highest margins at any point on the price deck.

There are huge implications for inflation. Much of what has happened has been deflationary. Demand for many goods and transport slumped. Unemployment soared. But there are other aspects that could be highly inflationary. If a bar or restaurant has to have fewer clients at any one time, it may have to charge more to those who wish to drink or dine at peak hours, just as trains have done for decades.

When goods are produced in rising volumes, their price normally falls as competitors force each other to offer the benefits of scale back to consumers. But if demand has fallen and scale is not available, producers will have to seek to raise prices, or accept lower returns going forward.

We do not profess to know how the myriad of possibilities will all play out. Suffice it to say that the future looks unusually different to the past right now. Our philosophy at HL Select has always been to try and identify the best, rather than the cheapest. We believe that makes our portfolios better placed to navigate challenges of all sorts. Owning businesses that generate robust cash flows and fat profit margins will always feel like a good idea to us, whatever the challenges ahead.

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