HL Select UK Growth Shares - Q2 2022 Review

Steve Clayton - Fund Manager

1 August 2022

Market review

Inflation, interest rates, war and recession dominated sentiment in the second quarter, and markets dropped sharply. The UK stock market delivered a total return of minus 5.0% over the period. Bucking the trend, tobacco stocks performed strongly, along with pharmaceuticals and defence companies. Banks and energy producers eked out minor gains, but at the opposite end of the scale, there were significant setbacks for automotive, industrial transportation and mining stocks.

Investors are concerned that the current strength of inflation, as much a global concern as a local one, will drive interest rates higher. This is being exacerbated by the war in Ukraine, on top of pandemic-induced supply chain disruption. UK inflation is especially pronounced, with the latest reported CPI rate of 9.1% far above the Bank of England's targeted rate of 2.0%. Sterling has weakened in response, dropping from an end-March level of $1.31 to $1.21 at quarter-end. This will further exacerbate the situation since significant imports like energy tend to be priced in US dollars.

The outlook here is unusually uncertain. On the one hand, the supply chain disruptions and other pandemic impacts ought to fade over time. Indeed the war in Ukraine exacerbated the situation, injecting a new urgency to food price inflation, but wheat, which surged almost 100% on the invasion, is now back close to its end-year level. Likewise, lumber prices, which had been driven up from around $300 per tonne to over $1,600 as economies began reopening, have now retreated to around the $700 level. What is unknown however is the degree to which labour prices will rise.

The labour shortages, from lorry drivers to bar staff, have been well reported, even if their origins are less clear-cut. Brexit may have contributed, but the UK has been far from alone in experiencing labour shortages. Either way, the degree to which wages rise will impact future price rises. Central banks fear allowing a wage/price spiral to develop. They also fear triggering recessions that undo the benefit of pandemic support packages. It is a delicate balance to strike.

It is improbable that supply chains cannot be repaired. They may well be reconfigured, given the increased desirability of manufacturing close to end markets. So we see longer-term constraints over the availability of goods and services as unlikely. But their cost is much more subjective. How quickly economies respond to rising rates will be critical. The faster they do, the less interest rates will need to rise.

Longer-term, the challenges and opportunities abound. We are only at the start of the digitisation process, and technologies like artificial intelligence have barely begun. The energy transition lies ahead, and there seem likely to be some near-term inflationary consequences. But ultimately, replacing fossil fuels with renewable energy suggests lower long-term energy costs, which ought to bode well for investor returns.

Q2 2022 Fund Performance Review: HL Select UK Growth Shares

The fund came slightly behind the markets' return, losing 5.3%* of value compared to the 5.0% market loss. The most significant positive contributions to the fund's value came from our technology sector position. Given broader weakness across growth-oriented markets like Nasdaq, this might seem counter-intuitive. However, whilst most of our technology holdings were weak, Ideagen bucked the trend after agreeing to be taken over at a substantial premium. Some of our largest losses arose in the Industrials sector, where the quarter's weak performances by Intertek, Experian and Diploma all impacted. We go on to discuss some of the detail behind the individual stocks that most affected the fund, up and down, over the period.

Past performance is not a guide to the future. *Source: Lipper IM to 30/06/2022

Significant winners and losers

Winners

Past performance is not a guide to the future. Source: Bloomberg (31/03/2022 – 30/06/2022)

This quarter's performance was dominated by one stock above all others. Ideagen has been in the portfolio for some time and had performed strongly over the years. Their business has a simple enough strategy - deliver growth by providing software that allows companies to fulfil their regulated functions. Whether that be internal audit, or monitoring airline safety processes, Ideagen provided essential assurance to their clients. It always seemed unlikely that Ideagen's clients would be told they could ease off on this stuff, far more likely that they would be told to increase it further.

In the end, multiple private equity firms saw this too, and the company attracted offers from several, eventually agreeing to one from Hg Capital for 350p per share. We first bought into Ideagen at 87.5p, leading to an eventual return on that investment of 300%. The stock traded above the bid value and we have so far sold half our holding, which had become the fund's largest single position.

We have long admired Unilever for its consistent value creation over time. More recently though, we have despaired somewhat at its execution. We are not alone it seems, and recently the company has seen legendary activist investor Nelson Peltz acquire a stake and be invited onto the Board. With the failed attempt to acquire GlaxoSmithKline's consumer health business behind it, we expect Mr Peltz to urge Unilever to take other actions to bolster the underlying pace of growth whilst screwing down on costs.

We bought into the non-voting shares of Schroders plc several years ago, arguing that this was a well-run business where the founding family had sufficient skin in the game to ensure that remained so. The discount attached to the non-voters was too wide in our eyes, given both voters and non-voters received the same dividend per share. During the quarter, Schroders announced the unification of the two classes of share, prompting a sharp jump in the non-voters' price. We still view Schroders as a strong business, but it is not as cheap as it once was given that leap up in price.

Losers

Past performance is not a guide to the future. Source: Bloomberg (31/03/2022 – 30/06/2022)

Ideagen apart, technology stocks were broadly out of favour in Q2. This can be seen in the performance of some of our holdings. To be clear, we do not believe these businesses have suffered any long-term damage. Adobe and Autodesk remain leaders in their fields globally, and Experian is continuing to add revenues organically, likewise GB Group. But with inflation buoyant and interest rates on the rise, investors are taking a more sceptical approach to how they value the earnings of these businesses.

Confidence in tech-led growth did take a hit during the quarter though, when Amazon revealed that they had over-estimated the pace of expansion and would be taking their foot off the pedal to allow the business to expand into the estate it had already built out. GB Group's e-commerce exposure is meaningful, but they have seen no slowing of demand, as evidenced in their recent full-year results that showed double-digit organic growth in revenues. Indeed their acquisition of Acuant has raised the structural growth rate of the portfolio, we believe.

Marshalls are the UK's leading producer of landscaping products. They are well managed, with a cash-generative business that sells to industry, the public sector and garden landscapers. Why they chose to leverage up just as interest rates are on the rise in order to acquire Marley, a leading producer of roofing systems, is a bit of a mystery to us. The market reacted negatively to the deal and the shares lost around a third of their value. Marley looks like a decent-enough business, but Marshalls admit there is not a lot of synergy in bringing the two together. They see an organic growth opportunity for Marley in the UK's ageing roofs.

We are torn here. Two reputable businesses have combined at a tricky moment in the cycle. Both would be better off without the leverage used to finance the deal. But neither is at great risk, although things could get a little sweaty for a while if the economy were to turn down sharply. However, leaking roofs do not fix themselves, and buckets are not actually a solution. Equally, landscaping projects can only be deferred so long before the site starts to resemble King Louie's palace in the Jungle Book. We will keep this holding under review.

Ascential had the most significant negative impact on the fund during the quarter. On the positive side, the group revealed it was contemplating whether its digital assets should be listed in the US, where they might attract a stronger valuation. On the negative side however, there was the risk that anything gained on Wall Street could be lost back home if the non-digital assets were de-rated. But we think the main headwind for the stock was the news from Amazon. That could portend a slowdown or reduction in demand for Ascential's services to brands, where it helps them to maximise revenues across the Amazon platform.

We can't really identify a specific cause for the pullback in Diageo's shares during Q2. The stock has been quite volatile of late, yo-yoing below its all-time high, set at the very start of the year. Spirits volumes were strong during the pandemic, and some worry that behaviours will normalise to their previous trends. Consumers could trade down to cheaper brands in response to the rising cost of living. But employment remains strong, with wages rising, suggesting we should not worry overmuch here.

Fund Manager Appointment

James Jamieson has joined the Select team to co-manage our UK funds. James has many years of experience gained in major investment businesses, most recently at RBC Global Asset Managers, where he ran pan-European Equity portfolios. James brings new valuation skills to the team and a thoughtful risk management approach. We look forward to seeing him driving the funds' performance ahead in future years.