HL Select UK Growth Shares – Q4 2021 Review

Steve Clayton - Fund Manager

28 January 2022

Market review

The final three months of the year saw the market push higher. A total return of 4.2% during the quarter built on earlier gains to create a full-year return from the FTSE All-Share Index of 18.3%. The market's strength came even as evidence mounted that inflation was proving to be more deeply established worldwide, not least in the UK.

Markets were encouraged by the evidence that although highly contagious, the increasingly dominant Omicron variant appears less likely to lead to serious illness.

The market's rise was somewhat erratic. The Beverages sector rallied strongly, up some 11.3% in the quarter as investors anticipated a wider reopening of the hospitality industry. Yet the Travel and Leisure sector delivered a negative return of 13.6%. Amongst the market's larger sectors, Banks were the best performer, delivering a return of 7.4%, whilst Oils were the weakest of the significant sectors, losing 1.4%.

The pandemic has created a series of challenges for businesses globally. Where production was shut down, shortages of goods have appeared. The interruption of logistics has left supply chains struggling to source all the required inputs. Price increases have rocketed, with factory input prices up 14.3% last month, putting manufacturers under pressure to push for increases themselves or face a squeeze on their profit margins.

The Bank of England has so far made only a token increase to interest rates, wary of stamping out the economic recovery underway. Most commentators expect limited further tightening, but we see this as finely balanced. Asset prices are buoyant, wages are rising rapidly, and the Consumer Price Index is already over 5%. Some counterbalances will help ease inflation in 2022, not least the dropping out of significant increases in 2021 from the year-on-year comparatives as the year progresses.

HL Select UK Growth shares performance review

The fund added 0.3% during the quarter, lagging behind the wider market performance. Indeed 2021 has proved relatively challenging for the fund, which delivered a full-year return of 8.6%, well behind the index. This underperformance effectively surrendered a portion of the substantial outperformance delivered over the last five years. Past performance isn’t a guide to the future.

The fund's style is to invest in high-quality businesses with robust finances and where we judge the competitive position to be so strong that the business has good prospects for delivering long term compound growth. Our belief in the ongoing digitisation of more and more economic activity draws us towards technology companies and other digital businesses. When these fall out of favour, we expect to lag but recover these periods over time through the longer-term growth they generate.

The biggest drags on performance in the quarter came from our technology and financials companies holdings, whilst our strongest contributions came from industrials and consumer staples holdings. Below we discuss the drivers behind the stocks which had the most significant impact, good and bad, upon the fund during the quarter.

Significant winners and losers

Winners

Past performance is not a guide to the future. Source: Bloomberg to 31/12/2021

Our strongest performers had a recurring theme: solid execution within their businesses, leading to encouraging trading news.

Experian is our largest holding in the fund and has continued to deliver robust operating performances. Interim results showed organic revenues surging 16%, margins expanding usefully and earnings growth of 30% accompanied by strong cash conversion. With economies recovering, Experian's ability to provide banks, retailers and other businesses with the digital data necessary to enable them to make decisions about who to lend to, where to best market their products or identify their customers is in rising demand.

Relx benefited from the market spotting glimpses of light at the end of the pandemic tunnel. It had seen its events business hit hard as many face-to-face exhibitions and conferences were cancelled and postponed. The prospect of these events being staged once again is a positive. More importantly, the group upgraded their growth expectations when they reported on Q3 trading back in October. Relx now sees growth trending above historical norms, with double-digit revenue gains in their Risk division the most significant driver.

Auto Trader played a solid strategic card through the worst days of the pandemic and earned loyalty from their motor trade clients when they offered their services gratis during the period when forecourts were locked down. We have a booming market in used vehicles, and the group's clients are in rude health. Partly it is a desire to avoid public transport driving demand. But also, a widely reported shortage of semiconductor chips has hampered new car production volumes, pushing demand back into the used vehicle segment. Interim results in November delivered record revenue and profit levels, and the group has successfully raised prices once more.

Diageo set out their growth plans in a Capital Markets event in November, which was well-received, enabling the stock to progress to new all-time highs in the weeks afterwards. The group launched a new £4.5bn capital return programme and highlighted twenty consecutive years of dividend growth, despite the pandemic. One of Diageo's enduring attractions to us is the strength of its cash conversion. Even during the 2020 financial year, when much of Diageo's licenced trade customers were forced to close, the group generated over £1.5bn of free cash flow.

Diploma announced exceptional full-year results in November. Revenues rose by almost 50%, profits by 70%, and margins leapt by 270bp, with the group converting over 100% of profit into cash for the second year in a row. Underlying revenues were up 12%, highlighting the strength of the core business, where all three divisions delivered robust expansion. Much of the growth came from the acquisition of Windy City Wire, proving to have been an excellent deal for Diploma so far.

Losers

Past performance is not a guide to the future. Source: Bloomberg to 31/12/2021

Both Ideagen and GB Group announced substantial acquisitions and placings of stock to part-fund those deals. Both seem rational acquisitions that expand the acquirer's range of activities into logical new adjacencies. However, neither was bought cheaply, and the market reacted negatively to the placings.

Our thoughts are that both businesses represent good long term growth franchises, and both have shown skill historically in using M&A to accelerate already strong underlying growth trajectories. Messaging on underlying trading from both names was positive during the quarter, and we remain strong supporters of these stocks for their long term potential. But there are periods when the market will greet deal-makers enthusiastically and times when it will not. With technology stocks generally struggling in the broader market toward year-end, these deals were unfortunately timed.

Sabre Insurance was held back by a pandemic-linked drop in revenue. Sabre provide motor insurance for non-standard risks. The pandemic hit premiums across the sector, which are proving slow to recover. Significant regulatory changes are now impacting the industry, which should benefit the group. Sabre has always priced for profit, not volume. Other insurers have tended to win customers through an unusually low quote, then raised the policy price at each renewal. The FCA now requires insurers to provide the same quotations to old customers as they would new ones. This should offer upside because Sabre's quotes should prove to be competitive in more instances if rivals are no longer subsidising new customers through the door. Either way, the group continues to generate cash and is paying attractive levels of dividends.

Close Brothers reported solid enough progress in their November trading update, but there was not enough to send analysts scurrying off to upgrade their forecasts. The lending book is growing by 2.4% in the group's Q1 to end November, but it does not look to us as if Close will add the same degree of market share that it has in previous recoveries. Following the financial crisis, new regulations obliged regular banks to strengthen their finances. So Close Bros' competitors appear better placed to maintain lending than in previous upturns. However, the group remains well capable of growth and is strongly capitalised, supporting future dividend payments to investors.

Outlook

2022 is likely to be a year when overall market performance in most major nations will be determined by the actual and expected levels of inflation and interest rates. If inflation returns to lower levels, without central banks needing to snatch the punch bowl away too emphatically, then there is much to be hopeful about. Ongoing low-interest rates in this scenario will support investment into equities generally, whilst the moderate rates of GDP growth implied by modest inflation ought to augur well for the performance of quality growth shares.

Should inflation prove stubborn and central banks become obliged to raise interest rates more significantly, then markets may struggle. Higher interest rates would increase the discount rates that investors use to value stocks. This could have a disproportionate impact upon highly rated shares, especially if they fail to meet the market's expectations for profitability or growth.

We will write a blog going deeper into our view of the outlook for markets shortly.

Our strategy focuses on companies with exposure to the fast-growing digital economy and which possess pricing power. If you can set your own prices, your product must be sought after: time then becomes your friend. Markets may well gyrate whilst it becomes clear what the actual direction of travel will be. But businesses with pricing power can grow their real earnings, whatever the level of inflation.

Past performance is not a guide to the future. Source: Lipper IM to 31/12/2021