HL Select UK Growth Shares – Q3 2021 Review

Steve Clayton - Fund Manager

26 October 2021

UK Stock Market Review

The quarter saw the stock market inch forward, with the market delivering a total return of 2.2% during the period, derived roughly equal from capital gains and dividends. The overall outcome is modest enough, but it masked strong currents beneath the surface.

Labour shortages, supply chain problems and most recently, a violent squeeze in gas markets have all been playing out in recent months. Economic recoveries have continued, although there are signs that the stresses within national markets may be starting to temper the pace of expansion. Inflation is rising in the UK, Europe and the United States, potentially bringing forward the timing in interest rate increases.

Perhaps unsurprisingly, rocketing energy prices helped the Energy Sector deliver one of the largest sector returns (+14.4%) amongst the major industry sectors, whilst Smith & Nephew led the much smaller Medical Equipment sector down 15.37%.

With economies reopened, we are seeing some upturn in Covid infection rates, especially in the UK. But vaccines appear to have broken the link between infections and severe illness or death. So barring the emergence of new virulent strains that can overcome the increasing immunity of vaccinated populations, major economies look set to continue the process of normalisation.

The virus has left huge public debts in its wake, and many corporates have seen severe cash outflows too. Normalising the public finances and bolstering balance sheets will take time, and higher taxes could restrain growth if imposed clumsily. The digitisation of economies will go ahead regardless, and indeed we expect the pace to accelerate. The pandemic exposed previously hidden risks in business models, from overdependence on lengthy supply chains to under-developed digital channels. Fixing these issues will inevitably see further investment into automation and digital capabilities.

Fund Performance Review Q3 2021

The fund delivered a total return of 4.0%* over the quarter, usefully ahead of the market return. Past performance isn’t a guide to future returns. The biggest drivers were our significant exposure to technology companies and strong performances from our holdings in the Industrials sector. Holding the fund back was a weak outcome from our Financials sector holdings, which lagged behind the market during the quarter. In the next section, we dig into the drivers behind the more notable contributions to the fund, good and bad.

Markets are facing the twin forces of enthusiasm stemming from ongoing recovery and pessimism surrounding the risk of rising inflation and post-pandemic disruptions. Much is made by observers of the possibility of a return to favour of Value investing, following a long period when markets have favoured growth stocks. Inevitably, there will be periods when Value, a style often associated with the commodities and financial sectors, has its time in the sunshine. Our style focuses on seeking out long term growth potential from cash-generative companies whose competitive position is strong enough to provide pricing power, critical in an inflationary environment. We believe this is the most consistent way of generating wealth over time.

The fund has significant exposure to technology businesses and digital leaders in other industries beyond the technology space. We do not plan on changing our style of investing for the simple reason that the digital transformation of the global economy will not stop. More likely, it will accelerate, increasing the opportunities for the type of cash-generative growth companies we favour.

Past performance is not a guide to the future. Source: * Lipper IM to 30/09/2021

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

Significant Winners and Losers

Winners

Past performance is not a guide to the future. Source: Bloomberg to 30/09/2021

Ideagen had a robust quarter and, as it is one of our largest positions in the fund, it gave a meaningful boost to performance in the process. We think the market is increasingly recognising the strength of the company’s strategic positioning. Ideagen’s software supports highly regulated businesses to comply with their obligations. So their customers tend to be sticky as switching to another solution provider can be onerous. Recent years have seen the company focus on migrating clients to a Software as a Service (SaaS) service, which creates strong streams of recurring revenues, making the businesses performance more and more predictable.

Royal Dutch Shell is one of the world’s largest energy companies, and its strong position in the Liquified Natural Gas market leaves it well-positioned to benefit from the current surge in gas prices. The company also made a major upwards shift in its dividend when it announced its second quarter results, going some way toward reversing the steep cut initiated during the pandemic.

Both Experian and Relx had strong quarters, backed up by what we felt were strong trading updates during the quarter. We like both these stocks for the predictability of their earnings and the growing market opportunities they face. Both are well positioned for digital commerce and have limited capital needs, leading to strong cash generation.

Paypoint took a beating a few quarters ago when it announced that regulator Ofgem had taken issue with the exclusive nature of its utility bill payment contracts. The group announced a settlement with the regulator during the quarter that effectively drew a line under the issue. The group can now focus on building upon the value of its Terminals fleet installed in tens of thousands of independent retailers’ stores. We would caution that utility suppliers' current upheavals could prove challenging for the bill payments service.

The reopening of economies has helped boost sentiment toward hospitality businesses, which will have supported Diageo of late. Their off-trade business proved resilient through lockdowns, but pubs and bars worldwide faced trading restrictions, and, as these restrictions are lifted, we expect Diageo’s revenues to recover strongly. Early signs are encouraging, with the company reporting that all geographic regions bar UK/Europe were delivering underlying sales levels ahead of their 2019 comparative.

Losers

Past performance is not a guide to the future. Source: Bloomberg to 30/09/2021

Sabre Insurance has seen the pandemic move from being a boost to profitability to a drag. Initially, empty roads meant few crashes and surging profits for Sabre. More lately, the group has suffered from reduced levels of new drivers, a core client segment. Sabre continues to earn strong returns on capital, however, it does need to demonstrate that it can fight off the challenges from newcomer businesses like Marshmallow that are focusing on peeling off some of Sabre’s higher-value customers.

London Stock Exchange Group has been under a bit of a cloud since announcing that the costs of integrating the Refinitiv acquisition were higher than previously expected back in March. Trading, however, seems robust enough, and the potential from the deal remains substantial. Their interim results reassured, with adjusted earnings per share growth approaching 20% and the disposal of Borsa Italiana has brought leverage down substantially.