HL Select UK Growth Shares - Q3 2023 Review

James Jamieson - Fund Manager

6 November 2023

Market review

Inflation expectations and the yield curve continue to be the key factors influencing how people feel about the economy and the value of assets. In simpler terms, these two things have been the main drivers of the financial market's mood. Not much else of note happened in the third quarter.

To explain a bit further, the yield curve tells us what people think interest rates will do in the future and how safe they think borrowers are. Right now, much of the talk has been about interest rates going up to fight inflation and how long this will last. While inflation is slowly getting better, worries about it going up again because of higher oil prices are on people's minds.

Lately, people have started talking more about something else: the huge amount of money the government needs to borrow to pay for its spending plans. This is a substantial change in the conversation. Central banks can quickly change interest rates when the economy and inflation change. They can also adjust the amount of inflation they want. But governments can't easily undo their spending commitments, so when people think they might have trouble paying their debts, they demand higher interest rates.

The conflicting information and changing opinions about all this made UK stocks quite volatile in the third quarter, but in the end, the FTSE All Share index rose by 1.9%* in the period under review. The focus on inflation saw a shift towards "value" stocks that helped the UK market, which has a high number of these types of stocks. So, sectors like Energy and Materials did well. On the flip side, companies focused on growth and those with larger debt did poorly because both groups suffer when interest rates go up. This meant that sectors like Consumer Discretionary and Utilities didn't do as well.

Fund Review

Our fund returned 1.8%* in the third quarter. Just like the overall market, the performance during this period was a bit all over the place. The types of companies we invest in had an impact, and we didn't do as well as we could have because we are underweight in Materials stocks. However, our portfolio did better compared to other investments. The main reason for this is that we had a bigger share of Energy stocks, which performed well. This was because, as mentioned in the Market Review, commodities that don't take long to pay off do well when interest rates are going up. The rising price of oil also helped, as we'll discuss in the Stocks Review section below.

Rather surprisingly, the Information Technology (IT) sector was another strong performer for us. Usually, when interest rates go up and there are worries about a recession, this sector doesn't do well. However, the IT companies that we hold have showed they can manage challenges and investors appear to be excited about new opportunities like Artificial Intelligence (AI). Perhaps investors believe that this time will be different, and profits won't drop significantly. Whilst we are cautiously in agreement with this sentiment, we know how quickly markets can change.

As with the market index, the Consumer Discretionary sector performed the worst for us. Even though we had some good performers like Next (see Stocks Review below), they couldn't make up for the overall weakness in this sector. It wasn't because we invested too much in it, but rather the profiles of the companies we hold within the sector, as we discussed in the Market Review. Similarly, the Industrials sector faced similar issues, despite RELX being one of the top 5 contributors to our performance.

Total Return (%): Fund v Index v Peers

Stocks review

Winners

BP and Shell are heavily influenced by the price of oil. Our investment thesis is centred on a strong oil price, as we've explained before. What gives us even more confidence in our short-term outlook is that US oil reserves are currently very low. With an upcoming election and high oil prices, it's unlikely that President Biden will significantly increase these reserves, as doing so could risk fuelling inflation during his campaign.

In addition, BP's CEO resigned due to governance issues related to undisclosed romantic relationships with staff members. This was the right action to take, and while it does introduce some uncertainty, we believe that the company's strategy and execution will continue smoothly. This is because the former CFO, who is now acting as the head of the company, has been closely involved in the ongoing changes and is well-acquainted with the business.

RELX appears here due to specific factors related to the company itself. We always prefer to focus on these "bottom-up" reasons for better performance, as they align with our core Select philosophy and purpose. In the case of RELX, we've seen that sustainable growth has increased for the company, partly due to the rapid development of Artificial Intelligence (AI), particularly in their Legal division. This has led to higher earnings and an improved stock valuation. Interestingly, earlier in the year, the stock price had dropped due to concerns about the impact of AI, but these concerns seem to have been proven wrong.

Furthermore, in the journals business, RELX has struck a deal with a group of German science organizations to provide open access. This resolves a longstanding dispute that had been affecting the company's shares.

HSBC features again, likewise for company specific reasons. Firstly the outcome from the regulatory stress test (which simulates how they would fare in a systemic event) was very positive, confirming their strong capital position. Additionally, the bank's Q2 financial results surpassed expectations, and its management expressed a more optimistic outlook for the upcoming year. Furthermore, HSBC is on track to deliver significant cash returns in 2024 because of divestments it has undertaken. These favorable developments led to analysts and brokers upgrading their recommendations for the company's stock.

Next's operating momentum is still coming through very well. During the three months they put out no less than two positive updates, increasing their expectations for the full year. Better weather than normal and an under-appreciation of wage increases invigorating shoppers want to spend with them were the reasons behind the improvement. Another highlight was booking an exceptional gain on the Reiss business they acquired. This is key to demonstrating the huge untapped value they can create from the Total Platform franchise and the equity deals that they selectively do around it.

Losers

Compass is a company that focuses on growth, but as we discussed in the Market Review, this category of stocks didn't perform well during this period. Compass had performed strongly in the past, so it's not unusual to see some degree of market correction or reversion. During the third quarter, Compass released a trading statement for Q3, which was satisfactory, but it didn't impress investors as much as they had hoped. This has been a trend we've observed for some time – stocks tend to get punished by the market unless their management consistently raises their future expectations. This is likely due to increased anxiety among investors and a desire for more certainty regarding short-term growth prospects. It's worth noting that the head of Compass's U.S. operations, a veteran in the company, is retiring. Given the significance of the U.S. market for Compass, this is an important change. However, we view the selection of the CFO as the replacement as a high-quality appointment, which provides some reassurance.

Experian is similar to Compass in that their focus on growth isn't popular right now, and even though they shared a good company update, investors didn't react well. We've looked at the competition, and we believe that, despite increasing competition in both their consumer and corporate markets, Experian is in a strong position to come out ahead.

Diageo is back in the picture, and it's been a bit frustrating. While their full-year results were okay, the fact that they didn't give any guidance for 2024 didn't win them much support, leading to continued lacklustre performance. We believe the soft sales volumes in the U.S. are temporary, and given the destocking process, it's challenging for the management to provide clear financial guidance right now. However, they did confirm their medium-term plans, which align with our outlook.

The new CEO did a good job in her first update, and our initial impressions are that she's the right person to lead the company forward.

OSB has been quite disappointing. It's a new addition to the portfolio, and before we invested, we did a lot of research including meeting with the company. They assured us that the trend of mortgage customers switching to a different rate after their fixed term wouldn't be a problem. Shortly after we finished our analysis and started buying the stock, they issued a profit warning for this very reason (customers refinancing faster, leading to lower earnings for the bank). This raises concerns about how the company is managed and how they communicate with investors. As a result, we won't be investing a large amount in this unit. However, in our opinion the stock was good value even before this happened, so we're holding on to it for now.

Ashtead’s recent weakness can probably be attributed to concerns about a possible economic recession. In the past, these worries would have been justified because the industries they serve are usually sensitive to economic ups and downs. However, Ashtead has shifted its focus more towards benefiting from U.S. government spending plans, such as bringing production back to the U.S. and investing in important industries. These areas aren't as affected by economic cycles. We thought that this change was well understood by now, so we're a bit puzzled by the recent weakness in their stock. Nevertheless, we're still confident in our investment in Ashtead.

Past performance is not a guide to the future. Source: Bloomberg (30/06/23 – 29/09/23)

The Outlook

The volatility and lack of direction in markets can partly be explained by the difficulty in determining where we currently are in the economic cycle. While this was never an easy undertaking and no two cycles are the same, it is especially complex right now because COVID dislocated many of the prior trends, while the policy response has brought about a new monetary and fiscal regime. Even after a year or two of normalization, the judgement isn’t much easier. We must try no less.

Stripping back the noise and confusion, one thing seems clear: that the indicators of business conditions are gradually seeing slowing momentum. Simultaneously, lesser followed data such as bankruptcies and corporate distress are accelerating. These references suggest that we are more likely late cycle than the early phase. Anecdotally the market seems to have moved to this thinking during Q3. After late comes recession.

We still don’t believe that the cost of equity reflects the risk of a downturn. There is no change to our prior view with the fund positioned to this end. As such it was a quiet quarter with only one new holding (Microsoft) and no exits.

China upscaling their stimulus efforts could see a pickup in growth, although we don’t think that the targeting or magnitude will be enough to change the global outlook meaningfully as it did historically. Bond vigilantes demanding higher yields to fund ballooning deficits would exacerbate a downturn should they successfully catalyse a credit crunch and force governments to curtail spending plans.