HL Select UK Growth Shares - Q4 2022 Review

James Jamieson - Fund Manager

20 February 2023

Market review

Markets ended the year in a better mood than they began it, with the FTSE All Share index delivering a return of almost 9% in the final quarter. After the shocks of the brief Truss administration, a period of more restrained policymaking was welcomed by the markets. The Bank of England supported pension funds by providing liquidity and the excessive premia seen in the government bond markets subsided.

Interest rates continued to rise, with two further increases in the quarter. At the time of writing rates sit at 4% but with inflation far above the target level, further rises seem likely. Much talk has been made of the squeeze upon household spending power from higher interest rates and rocketing utility bills, with their impacts exaggerated by below-inflation wages growth. So far though the economy looks to be limping along.

The most recent GDP data showed a -0.3% decline in the three months to November, which sets the stage for a lacklustre pace of growth in the quarters to come. The depth of the UK’s recession in 2023 is still up for debate. Strikes in the public sector and some privatised industries will be acting as an additional brake and whilst utility costs look set for further hikes, the proportionate increase is unlikely to be as great as that seen in 2022.

Amongst the major sectors of the market, Pharmaceuticals, Banks and Miners rose more than the wider market. Telecoms has performed so badly for so long that these days, it isn’t really a major sector. Having already shrunk to the point where it accounted for less than 2% of the market’s value at the beginning of the quarter, it still managed to be the worst performing sector over the period, losing another 11% in value. Oil and Gas stocks lagged the market slightly, in sharp contrast to the wider global market where they were the leading sector of all. Perhaps UK investors decided to punish the “Sin Sectors” in the quarter, for both Alcohol and Tobacco producers were also notably weaker than the wider market.

Fund Review

The portfolio delivered a total return of 5.2%*, lagging the market over the three months. The underperformance can roughly be attributed equally between one stock (GB Group) and the Value style leading the market. As you know HL Select is focused on Quality and Growth rather than the Value style of investing. In other words we mainly invest in businesses with attractive prospects, stretching a long way into the future, with strong competitive defenses. We seek to avoid businesses that might appear optically cheap, but where prospects are unattractive beyond the very short term. Of late though, Value has been in vogue. While we try to limit this impact as explained in the last blog, we remain true to our philosophy and have no intention of changing our spots to stripes.

In terms of sectors, Industrials made the biggest positive contribution to the fund’s value. This is a very diverse group, from capital-intensive manufacturers through to capital-light digital platform businesses. Diploma was our stand-out performer here (see Stocks Review below). Financials were also strong. In particular Lancashire Holdings and Close Brothers shone for us (see Stocks Review below). At the other end of the spectrum, Information Technology did not fare well over the period given its low exposure to the Value style. In addition to the sector performing badly overall, GB Group had an especially tough quarter as explained below. Communication Services was also weak, underperforming other areas of the market.

Total Return (%): Fund v Index v Peers

Past performance is not a guide to the future. Source: *Morningstar Direct to 31/12/22

Stocks Review

Winners

Rio Tinto was the biggest contributor during the fourth quarter. In many ways, this is an unusual position for us, for it is generally regarded as falling into the Value camp. However, Rio possesses some of the lowest cost iron ore reserves to be found. This offers tremendous cash flow potential so we are happy to hold it. These cash flows give it the ability to fund its own growth for years to come, and it also helps prevent our Growth style from becoming too unbalanced. The Chinese authorities U-turned on their conservative COVID-19 policy which caused investor excitement on expectation of better demand for metals. This is undoubtedly good news for Rio in the near term, but the fragile state of global economies could still cause problems later on and we will manage our exposure to Rio Tinto accordingly over time.

Lancashire Holdings delivered a bullish trading statement in November, with strong Premium growth alongside strong renewal pricing. Lancashire also guided that full year premiums would be top of the range. Improved pricing due to scarcity of capital is a core part of our investment thesis so we are encouraged to see it coming through. Another positive is the UK Treasury’s proposal to reform the capital requirements imposed upon insurers. While there is no timeline yet, any such change would see a release of capital that could be used to generate higher returns for the company.

AstraZeneca is always announcing news flow. But we think sentiment played the larger part in the stock’s strong performance in the quarter, given the relatively minor nature of company announcements in the period. We see AstraZeneca as offering the best growth profile in the sector, so perhaps the market is beginning to agree?

Next also put out an encouraging trading statement. Impressive given there aren’t many UK-centric retailers that we know that are delivering improving operating results in the face of the current challenges. Exceptional dexterity and vision from management have seen them adapt to the changing high street by shifting business online, rationalizing the store footprint and better utilizing the physical shops by becoming fulfillment centres for other smaller retailers. We believe this won’t only ensure their survival, but their size and relatively stronger position enables them to capitalise on the changes by taking share and striking deals on favourable terms. The acquisition of Joules during the quarter is a great example of this.

Haleon has been performing consistently well for some time. The company is the world’s largest consumer health pure-play having been spun out of GSK earlier this year. When a big company like this appears in the investment landscape, it takes time for people to get abreast of what they do. Then investors must process the information, model their assumptions and try to work out what they think the spin-off is worth on its own two feet. Shortly after Haleon was spun out there was a bout of negative publicity about litigation surrounding Zantac, one of former parent GSK’s drugs. Haleon have always maintained they have no liability here. A positive federal court ruling surrounding Zantac litigation in the US may have encouraged other investors to conclude, as we had already, that Haleon, freed from the constraints of its parent, has potential to shine in its own right.

Past performance is not a guide to the future. Source: Bloomberg (30/09/22 – 29/12/22)

Losers

GB Group has been the frustrating victim of timing. In Q3 it was the top contributor in the fund after receiving a takeover approach from private equity. Capital market conditions changed during the negotiation period, and the surging cost of debt led to the bidder failing to make an offer sufficient to win GB over. Higher borrowing costs have challenged the economics of leveraged private equity transactions more broadly. Anecdotally this has resulted in a record decline in Mergers & Acquisitions (M&A) in recent months. The takeover failed to materialize at a time when Information Technology, Mid Cap and Growth stocks were very out of favour.

The company put out a decent enough trading update in November. As you might imagine we have been doing extra work to stress test our assumptions and engaged with the company to re-appraise the situation. We found no cause to revise our expectations at this time and now see even more upside to the investment than we had done prior to the bid talks.

The following laggards all shared the same principal driver of underperformance, which is their Growth, rather than Value, credentials. So to avoid repetition like a broken record, let’s focus instead on the other salient developments over the three months.

Diageo released a solid trading update in October, confirming a good start to their fiscal year in all regions. We are especially interested in companies that have the potential to come through tough times in even better shape thanks to their superior position and attributes to begin with. Like Next, Diageo is another good example of the strong getting stronger. The group’s strength allowed it to continue acquiring smaller rivals throughout the period, despite the wider M&A slow-down. To us, this only confirms that Diageo enjoys the privileged position, shared by few others, of controlling their own destiny.

London Stock Exchange (LSE) is in the same camp. But it is a joint venture struck with Microsoft that we think is really important as it accelerates the transition of their offering to the Cloud, which we feel will lift growth in future years, once the heavy implementation work has been done. Furthermore Microsoft have taken a 4% stake in LSE as part of the agreement and appointed their head of Cloud technology to LSE’s board, which is a big show of confidence and aligns all stakeholders.

Autodesk was in the winner’s camp last quarter so there is an element of reversion here. That being said, results published by the company were somewhat mixed and guidance fell short of expectations. Nothing dramatic that changes our view but it’s a time when the market is being especially unforgiving. As leaders in the design and build technology market, they are very well positioned for the secular growth opportunity in this space, irrespective of the short-term machinations of the cycle.

Ascential disappointingly features again. There is nothing out from them since we last wrote on it and as alluded to earlier, the negative current against smaller companies has continued.

Past performance is not a guide to the future. Source: Bloomberg (30/09/22 – 29/12/22)

The Outlook

The new year has begun smoothly enough, with the FTSE All Share index a few percent higher. But the economic course ahead is far from clear, making forecasting where the market is heading unusually fraught. Interest rates are very likely going higher, but by how much? Monetary policy works with famously “long and variable lags”. It would not be daft to interpret that as economists saying, “we don’t really know what impact a change in interest rates will have, nor when it will be obvious that it has had any”.

All that we can do as fund managers is to focus on how we find businesses trading and listen to what their managers are saying about their customers’ behaviours. We will learn a lot more about that when companies release results. So far we would say that most managers are taking trouble to sound cautious, whilst generally reporting pretty solid numbers. But change is clearly afoot. Conflict in Ukraine continues with little sign of any resolution. The UK housing market has clearly slowed down. Meanwhile on the other side of the world, China is adopting a more growth friendly position and reopening after very stringent COVID-19 lockdowns.

Einstein was fabled to have said that compounding is the eighth wonder of the world and those that understand it earn it, while those that don’t pay it. This is the genesis of HL Select and we remain resolutely focused on finding these compounders. We believe this is the best approach to long term investing and navigating periods of low visibility. To this end, Cranswick plc was added to the portfolio during the quarter. The rationale for which can be seen in the Portfolio breakdown.