HL Select UK Growth shares Q3 2020 review

Steve Clayton - Fund Manager

14 October 2020

Market Review

The FTSE All Share index lost 2.9% (total return) during the third quarter as the market recovery of the previous quarter ran out of steam. The quarter was characterised by relatively small rallies and repeated fades as sentiment was tugged in opposing directions.

With economies at home and abroad suffering sharp contractions as nations locked down, investors were scanning for signs of recovery with each passing month. The evidence is mixed. Millions of workers remain on job support schemes, which will eventually end. Massive amounts of stimulus have been lavished by governments around the world. Gauging the underlying position is challenging.

But economies are definitely stronger than they were, and in our view, stronger than might have seemed likely a few months ago. So far, stimulus has proven effective. Of course challenges remain, not least the weaning of companies and employees off job support schemes. This will not always end well, but some businesses will reabsorb most, if not all of their former staff.

So a base is being built, and the questions are shifting toward what growth rates may be seen in the years ahead. During Q3 the market anticipated a stronger consumer, pushing retail shares higher. Stimulus measures augur an increase in physical investment, which drove mining stocks forward. On the flip side, confidence in the outlook for energy companies and banks ebbed, sending those sectors lower. Lower energy prices directly impact energy companies’ cash flows. For banks, ultra-low interest rates are now seen persisting for some time, limiting their ability to earn attractive interest rate margins.

Events in the UK market, and indeed almost everywhere else, were largely eclipsed by an extraordinary recovery in US technology stocks, with the US Nasdaq index rising to new highs, as the market bets on the digital economy outperforming traditional business models for years to come.

Performance Review

The fund delivered a total return of 0.4% in Q3, which compared to the FTSE All Share Index total return of -2.9%. The main drivers behind the outperformance were strong contributions from our technology stocks, which added around 1.5% to the fund’s value and some strong performances from holdings like Unilever, Next, Adobe, Intertek and London Stock Exchange. Holding the fund back was its lack of mining shares and its holdings in Royal Dutch Shell, Relx, Paypoint, Autodesk and British American Tobacco. We discuss the events behind some of these performances below:

Over the year to 30 September 2020 the fund delivered a total return of -0.7% compared to the FTSE All Share Index return of -16.6%.

Past performance isn’t a guide to the future. Source: Lipper IM 30/09/2015 to 30/09/2020.

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

Significant Winners and Losers in Q3 2020

Winners

Past performance is not a guide to the future. Source: Bloomberg (30/06/2020 – 30/09/2020)

Unilever was a significant positive contributor this quarter after reporting a resilient half year earnings performance and unchanged quarterly dividend. Unilever is very used to managing through crises, given its significant exposure to emerging markets, which tend to be prone to periodic bouts of instability. This, combined with the strength of Unilever’s balance sheet and cash flows means it is well placed to emerge from this crisis stronger, with scope to gain market share from weaker rivals.

Next’s half year results were very Next-like. The financial performance was extremely resilient in the circumstances, with the business eking out a small profit in the 6 months to the end of July despite the closure of Retail stores and disruption to warehouse operations during the period. Even more impressively, the business gushed cash, resulting in a £350m reduction in net financial debt.

This robust financial position is allowing Next to continue investing in its business, at a time when many competitors (e.g. New Look, Debenhams) are in serious trouble and can only think of survival. A particularly exciting Next initiative is Total Platform. This allows third party brands to partner with Next, tapping into its online logistics and distribution network. The appeal of a service like this is it allows brands to focus on what they are good at, namely branding and design; while leaving Next to handle the unglamorous but essential guts and guttering of running an online business, like warehousing and returns.

Incremental investment requirements for Next are fairly limited, because it’s spent two decades building out and refining its online platform. Next can charge a commission on partner brand sales; so this has scope to build into a lucrative profit stream over time. To us, Next is a classic example of a strong business getting stronger during this pandemic.

Adobe’s third quarter results were predictably strong. The business is firing on all cylinders, benefiting from increased demand for digital services like document sharing and digital media. The shares have performed well lately, and may be due for a pause for breath. But in the long run we see plenty more to go for as most parts of Adobe’s business are in the sweet spot of digital commerce.

Both Intertek and LSE also released strong half year results during the quarter. The biggest driver of LSE’s performance over the next couple of years is likely to be the integration of Refinitiv. This acquisition is transformative for LSE given the size and depth of Refinitiv’s data assets and the significant potential for cost synergies. The deal is expected to complete by the end of 2020 or early in 2021.

Losers

Past performance is not a guide to the future. Source: Bloomberg (30/06/2020 – 30/09/2020)

Relx was a little weak following its first half results, which to us contained little in the way of surprises with weakness in Exhibitions and print books, and resilience in electronic and digital revenue streams. Cash generation was very strong and the dividend was held underpinning a current yield of around 2.5%.

Print declines of c.20% are of little consequence to our long term investment case and print is now just 8% of overall revenue. The outlook for Exhibitions is very uncertain in the short term but as soon as we get a vaccine we expect this business to recover. The outlook for electronic and digital revenue streams looks good to us and has been reinforced by recent portfolio actions to add more digital/identity assets to the portfolio; while demand for databases and tools continues to grow.

Autodesk saw a bit of profit taking following half year results, which were in line with our expectations. Although current economic conditions create uncertainty for Autodesk’s customers, we remain excited by the long term opportunity. The secular trends that Autodesk has been investing in and preparing for, such as the adoption of cloud-based solutions, are accelerating leaving the group very well positioned in our view.

Oil prices remained low and Energy companies are deeply out of favour and Royal Dutch Shell was no exception. Transport activity, especially aviation has been hit hard, lowering demand for fuel. Oil prices have remained depressed, even if we did not see a repeat of the shenanigans of Q2, when prices briefly turned negative. The world desires a greener future and energy producers are trying to cut the carbon intensity of their output. Right now investors are sceptical, but the energy transition will be long and drawn out, requiring substantial hydrocarbon production for some time to come. So it may be too soon to write off the oil majors just yet.

Paypoint shares did very little until the last day of the quarter, when they revealed that the regulator Ofgem had written to them, raising potential objections to the nature of the exclusive arrangements Paypoint have with utilities to allow customers to pay their bills via the Paypoint network located in independent retailers. The shares dropped sharply to end the quarter 15% down. The matter is now open for consultation and review and we await further news. We were surprised by Ofgem’s actions. The contracts enable the network to exist and create the ability for consumers to pay for key services at convenient locations nationwide.

New holdings – Primary Health Properties (PHP) and Lancashire

We participated in the £120m equity placing of Primary Health Properties (PHP) on 9 July, adding just over 3 million shares at a price of £1.45. We have owned PHP in our HL Select UK Income Shares fund since launch, so we know the company and management team well.

PHP owns a portfolio of over 500 modern, purpose built medical centres across the UK and Ireland. All are held on very similar leases, which are upwards-only in rents and of long duration (>12 years on average), with 90% of rents backed by the UK government. As such, PHP’s portfolio is exceptionally resilient. The Covid-19 crisis has reinforced this, with rents having been received as normal and the forward development of new build sites progressing.

The recent equity raise gives PHP the firepower to continue expanding its portfolio, which combined with underlying rental growth from existing assets, should support further dividend progression (the current yield is around 4%, variable and not guaranteed). While we don’t specifically target income in this fund, we value resilience in the current highly uncertain environment and expect companies like PHP, which can not only maintain, but grow, their dividend during a crisis, to remain highly sought after.

We also initiated a c. 2.5% position in Lancashire Holdings, a specialty insurer focused on the Property, Energy, Marine and Aviation segments which we expect to be a mid-to-long term beneficiary of the Covid-19 crisis.

We believe the crisis will pile further pressure on the wider insurance industry, which was already struggling from a spate of catastrophe events in recent years; resulting in large scale industry capacity withdrawal. As supply retrenches, prices should rise (harden) providing a very attractive growth opportunity for those insurers willing and able to exploit it.

We back Lancashire to be able to do so. The group has a superb track record of underwriting, generating higher margins and returns on equity than most of its peer group. We believe the strength of Lancashire’s balance sheet combined with very manageable Covid loss exposure (estimated at around $42 million at July 2020) means it is well placed to capitalise on this opportunity.

Full rationales for these purchases can be found on the portfolio breakdown page.

Outlook

In the next few months, America elects a President. Will they dump Trump, or vote for four more jaw-dropping years? Will President Trump be fully recovered before the election? Brexit will happen, one way, or another. The economy and the virus will be closely intertwined for a while longer yet. Uncertainties abound. But what we can be pretty sure of is that money will remain astonishingly cheap for some time to come. So far the economic lesson of the pandemic is that cheap money beats just about anything. With economies trying to bounce back, that cheap money is likely to have ever more powerful effects.

We will maintain our focus on cash generative businesses with strong competitive moats. We believe this is the best way to achieve superior returns in the long run, even if it means that sometimes we will be holding stocks that are out of favour. Our belief is that as long as the business itself is robust, market sentiment can puff and blow, but in the long run the superior financial performance of top quality business will win out.

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