HL Select UK Growth Shares - Q4 2023 Review

James Jamieson - Fund Manager

5 February 2024

Market review

UK Equities returned +3.2% in the final quarter of the year. October was very weak, but with the US Federal Reserve (Fed) signaling an end to interest rate hikes, a big rally was sparked in the markets for November and December. What motivated the Fed to pivot so radically and so quickly is not yet clear and will determine how markets perform as we move through 2024 and the reality is digested.

Falling interest rates can support economic growth by lowering companies’ and citizens’ borrowing costs. This tends to support the stock market as long as it does not believe that Central Banks moved too late. So far, the Transatlantic economies have largely avoided recession despite many predictions to the contrary. If economies continue to hold up, lower rates should be good for company earnings when they finally appear. As always, the path of inflation will determine how this all plays out.

The strong performance in Q4 suggests that investors are betting that recession will not intervene and that falling rates will indeed support earnings in the years ahead. But for the Central Bank to cut rates during 2024 as many times and by the magnitude implied by the yield curve at the time of writing, there would likely need to be a harder landing than the market currently believes. Which would be bearish, not bullish as the 3-month performance suggests. Central Banks can sometimes see things that investors can’t because they have more, and earlier, access to data. So it’s all eyes to the data published from here.

Looking at the composition of the market gains, Industrials were the star sector, especially the Capital Goods Industry. This is surprising given economic indicators are rolling, even though these stocks typically perform in advance of an upturn. For contradictory reasons, Energy was the main laggard as concerns over demand and surplus reserves outweighed war in the Middle East and action from Saudi Arabia to support the oil price.

Fund Review

The fund delivered +3.2%* performance in Q4. The period pre the Fed’s pivot was especially good for us as the low volatility nature of the portfolio was well bid given the nervous sentiment in markets. The latter part of the quarter remained positive but it’s interesting to note that although our quality and long duration style participated (falling interest rates are a tailwind for these businesses as explained previously), low quality and high cyclicality did even better. Past performance isn’t a guide to the future.

Under the bonnet, what worked for the fund was broadly similar to the shape of the index. On the positive side, Industrials were strong thanks to our overweight rather than stock selection. Our bias to Business Services did well but to a lesser magnitude than higher octane Capital Goods where we had lower exposure. Financials were a key contributor in the portfolio. Pleasingly this can be attributed to a number of holdings doing well for specific reasons. OSB was the stand out (see Stock Review).

As mentioned in the Market Review, Energy had a poor quarter due to a fall in the oil price. As explained in previous updates, these stocks are highly correlated to the commodity so you would expect to see the group at the bottom. Company-specific issues at BP added to this (see Stock Review). Staples were the other main detractor, unsurprising given the group’s defensive profile in a risk-on market. Furthermore some of the key constituents are having a difficult time. More on this below.

Total Return (%): Fund v Index v Peers

Stocks review

Winners

Experian was marked down last quarter as peers, like Intuit’s Credit Karma division, reported weak numbers and lowered their outlooks. We concluded that the company is well positioned for resilience and solid H1 results have vindicated this view with their competitive advantage demonstrated and rewarded. Core growth drivers are in their infancy and penetration has a long runway ahead. So notwithstanding some degree of short term cyclicality that could impact them, we remain constructive.

RELX makes the leaders board yet again and there isn’t a great deal to add from the last update. The Q3 report put out by the company was satisfactory and the business is performing well on all sides. A multitude of broker upgrades has likely helped elevate the shares. It is the largest active position in the fund and despite managing the concentration risk, it remains so.

LSE is one of our highest conviction stocks, reflected in its top 10 status. For a long time it has been a complicated proposition which has weighed on the stock, herein lies the opportunity. Clarity is beginning to present and while visibility of the strategy working has been coming through for some time, a comprehensive series of investor days has helped improve understanding and unlock value. As has the move to a more granular reporting methodology and an increase of medium-term targets, the strategy foundations are in place and delivering. The appointment of a new CFO has also removed uncertainty. The backdrop laid out in the Market Review also favours this type of asset.

OSB, like Experian, has gone from bottom to top. Given it is small and carries lower liquidity, there is likely to be a degree of reversion momentum in the strong performance that came through in Q4. Regarding company specifics, the Q3 trading statement showed no further deterioration in customer behaviour that had caused such an impact before. Growth continued to evolve well with limited credit impairments, these were of course the main reasons we deemed the stock as good value at the time. Consequently the bearish commentary around the stock largely evaporated and eased the pressure upon it. Despite a big rally, we still see significant value with the potential to return over 50% of the market capitalisation in coming years, though as always any returns are not guaranteed.

Diploma has seen good operating momentum over the year, with the commensurate share price appreciation you would expect. During the quarter they put out a terrific set of full year results which were ahead of expectations and culminated in upgrades to earnings forecasts. Like RELX, while looking a little stretched in the short-term from investor exuberance, it remains a core holding.

Losers

Rentokil revealed a disappointing operating performance at their Q3 update, resulting in negative revisions to earnings estimates. The poor share price response has been disproportionately greater, highly rated darlings such as this always fall hard, especially in this market. The nub of the issue is slowing revenue growth in the US, alongside some softer outlook commentary concerning demand. Investors are particularly sensitive to this given the transformational Terminix acquisition which they are currently integrating. At this point we maintain that the issues are transient as they digest the new asset and that the overriding thesis remains intact.

BP was a winner last quarter, and like all Energy names, was dragged by a declining oil price this time around as discussed above. In addition, they put out soggy Q3 results with the star Gas Trading unit not delivering to its usual form. Meanwhile the company remained without a permanently appointed CEO and thus clarity on the future strategy. These are all things that investors don’t like. On a more positive note, Fitch did raise their credit rating reflecting ongoing debt reduction and steady energy transition progress. This bodes well for a potential increase in the buyback.

BAT has seen a flurry of negatives: UK minimum age regulations, antitrust fines in Nigeria and the FDA denying marketing authorization in the US on 6 flavored vapes which includes the number one selling menthol product. While posing headline risk and impact, these don’t materially concern us. What does, is the company writing down half of the Reynolds goodwill which they acquired in 2017. This demonstrates poor capital allocation and casts doubt on the ability of the legacy cash cow business (that Reynolds is part of) to facilitate transition to the new categories. Operating guidance was also revised to the lower end of the range with implications of the buyback taking longer to materialize. Despite a low valuation, we have reduced the position and it is under review.

AstraZeneca is out of favour, along with the rest of the Healthcare space. It really is as simple as that and has been the case for much of 2023. During the quarter they released a good update, with commensurate upgrades to forecasts. It made no difference. We see value in this best-in-class innovator but its large absolute weighting makes it hard to increase materially.

Diageo finally provided guidance for 2024 containing less than satisfactory expectations. While partly attributed to the ongoing destocking issues, the main negative was an unexpected deceleration in Latin America which is being heavily impacted by the macro-economic situation. So the bad times endure and support has dwindled with nothing obvious in the very short term to reverse this. Like Rentokil we still believe and don’t see the world class brand portfolio as impaired.

Past performance is not a guide to the future. Source: Bloomberg (29/09/23 – 29/12/23)

The Outlook

While calendar years don’t have any bearing on the fund, let’s use the marker to meditate on what has come to pass and where we might be going as we head into 2024. So a slightly longer concluding section than normal. In summary, the wall of worry was ultimately climbed in 2023 with pockets of strength carrying pockets of weakness, and no major systemic events coming to the fore. Bizarrely, sitting here today is reminiscent of this exact point last year with many of the same issues still outstanding and little visibility on any of them.

However, there is one profound point of difference among the list of significant ongoing risks: disinflation is now coming through on all sides and as mentioned, the main Central Bank actor (the Fed) has indicated interest rates are at peak. This is a good direction of travel and we do subscribe to the Fed pivot, although we expect the journey will be choppy and suspect the market has got ahead of itself. With this in mind we anticipate volatility yet are now more comfortable adding to our preferred core Select exposure (which faces headwinds as interest rates rise). Reacceleration of inflation born out of oil and shipping costs due to escalating conflicts is being monitored closely.

Two new positions were established during Q4. Redrow is a housebuilder and was initiated ahead of a recovery. It is hard to know when this may materialise but any demand-side policy initiatives into the election could be a driver short term, while substantial returns can be made medium term when the broken market normalises. Games Workshop was also added and is a classic Select compounder. If our work is correct, this investment could create considerable long-term value from their excellent IP and an enormous runway for growth. See the rationales on the website for more detail.

When looking at the micro prognosis for equities, there is little change from our view at the Q3 update: leading demand indicators are rolling and earnings revisions continue to be negative. Yet share prices have marched on, in turn elevating the risk of a sell-off if this realisation beds down and/or becomes a reality. Big picture tail risks are also familiar: China has refrained from major stimulus and sentiment is low, so a positive surprise would be supportive for global growth. Meanwhile a delayed hard bite from tighter credit conditions remains the main negative tail risk.

Unlike 2023, the year ahead will see politics become a central issue with approximately half the world’s population set to vote. Two of these elections are very important for us. The US is scheduled in November and matters for everyone. Trump leads but the situation is fluid. His appointment was positive for equities last time but the starting point is different now. The UK has no fixed date although sometime in Autumn is mooted. A Labour government seems like a foregone conclusion but it is early days. If this plays out, it shouldn’t be negative but the detail contained in the policy initiatives will decide. Politics can create noise. Our real concern is on how a new government’s decisions impact our companies’ operations and the economic profit opportunity.