HL Select UK Growth Shares - Quarterly Update

Steve Clayton - Fund Manager

22 October 2019

The stock market drifted sideways through July before a brief dip in August, followed by a rally in September to leave the FTSE All Share Index fractionally lower at the end of the period. Dividends paid out during the quarter meant that overall, there was a total return for the All Share index of 1.3% for the period.

Investors had plenty of distractions to cope with; trade wars ebbed and flowed, Brexit led British politics into the courts and a new Prime Minister lost his majority in Parliament on purpose and clocked up more Parliamentary defeats in his first few weeks in office than most predecessors managed in their lifetimes. In the background, economic indicators deteriorated at home and abroad and the level of interest rates was cut in both the USA and the Eurozone.

At the time of writing, the Brexit outcome is still very much up in the air. The end result may well be significant for the direction of sterling, if the currency’s reaction to the referendum result is any guide. When sterling moves, the value of companies’ overseas earnings moves with it, but in the opposite direction.

The next few months have the potential to be volatile as a result, and it’s quite possible the UK market could perform very differently to other global equity markets in the near term. In the long run Brexit will simply be one of the many challenges that businesses have to navigate around. Of more concern to many boardrooms will be whether the culmination of the Brexit process will lead to a change of government in the UK. Please remember that past performance is not a guide to the future. All investments and their income will rise and fall in value so you could get back less than you invest.

Fund performance

The fund was little changed last quarter with relatively few holdings making much of a contribution, good or bad. Of those that did, Burford Capital was far and away our largest detractor, even though the holding added significant value over the entirety of the period that we held it. A relatively recent holding, London Stock Exchange was the best positive contributor during the quarter, reflecting major deal activity and a takeover approach.

Past performance is not a guide to the future. Source: Lipper IM, Correct as at 30/09/2019.

Annual Performance

Past performance is not a guide to the future. Source: Lipper IM, Correct as at 30/09/2019.

N/A† full year data unavailable as the fund launched in December 2016.

Strongest contributors

Past performance is not a guide to the future. Source: Bloomberg, Correct as at 30/09/2019.

LSE buying and being bought

London Stock Exchange (LSE) was by far the biggest positive contributor, after agreeing to purchase Refinitiv, followed by a bid approach from Hong Kong Exchanges and Clearing (HKEX), which has since been dropped.

We see many positive aspects to the proposed Refinitiv deal. First and foremost, Refinitiv looks like a high quality business. Data, distribution and analytics account for 75% of Refinitiv’s revenue and these are mainly sold on subscription, leading to a high proportion of high margin, recurring revenues. The world is using and analysing more data, and combining LSE’s existing data assets with that of Refinitiv has scope to create significant value for customers.

We also like the price paid, which looks low, especially if LSE can deliver on the £225m of revenue synergies and £350m of cost synergies that they target. If these sums are right it means the deal has the potential to deliver around a 30% increase in profits for LSE shareholders in the first full year post completion, increasing further in years 2 and 3. This explains why the shares have reacted so favourably.

Of course, it’s far, far easier to plug a few numbers into a spreadsheet than it is to successfully deliver on a large scale merger. And make no mistake, the risks of combining these two businesses are high. Leverage will also increase significantly, although it should reduce rapidly given the cash-generative nature of the combined entity.

On balance, we think the pros of the deal significantly outweigh the cons and so have retained our position, although we will monitor the situation closely.

Pests don't care for politics

We have often commented in the past that the majority of the companies we own depend very little on the health of the UK economy. Pest control specialist Rentokil Initial is a case in point. Half year results showed the business continuing to make strong progress with mid-teens percentage growth in profits and the dividend.

Rentokil earns the bulk of its profits overseas and provides services that are largely immune from what’s happening in the economy (the pests don’t seem to care much about Brexit or Trump trade wars!). The shares have therefore benefitted from UK domestic worries prompting a flight towards perceived ‘safe-havens’.

Compass pointing the right way

We hold Compass Group for its consistent delivery of steady growth, backed up by robust cash flows. The group is the world’s largest contract caterer, with heavy exposure to the USA. Their trading update, issued in late July showed continuing robust growth in North America, where organic revenues pushed ahead by 9.5%.

Beyond America, growth was more lacklustre, with margins pressured in the UK, France and Germany, but making progress elsewhere. Overall the group achieved organic growth of just over 6%.

Experian delivering on demand for data

In a world increasingly focused on the role of Big Data in driving economic progress, perhaps we shouldn’t be surprised to see Experian making solid progress. With their origins in the credit bureau world, Experian’s mission has always revolved around helping organisations, and now individuals, make better informed decisions through accessing accurate and timely data.

Organic revenue growth in their last quarter was 6% at constant currency rates, underlining how well the business is positioned to grow, even in challenging economic conditions.

Just Eat, just sold

We sold out of Just Eat in the quarter, after it announced an agreed, all share merger with Takeaway.com - a European rival. In truth, there is little overlap between the two, despite both operating in the online food delivery sector. So we can’t see huge synergies to be won.

Just Eat had a management vacuum, having parted ways with their former CEO and an activist investor agitating for change. So we could understand why the board might have embraced a deal.

Competition in online food delivery remains intense though, with Deliveroo and Uber Eats snapping hard on established players’ heels. So we took advantage of the boost to Just Eat’s share price and exited the position.

Weakest contributors

Past performance is not a guide to the future. Source: Bloomberg, Correct as at 30/09/2019.

Burford still in muddy waters

Burford Capital fell sharply following a short selling attack. We’ve written at length on this already, explaining our decision to exit and the impact of the position on the fund over the entire period that it held the stock. During the quarter the position impacted performance by 2.5%.

Claims and counter claims by Burford and Muddy Waters continue and resolving the truth of the situation will be a protracted business, given the nature of litigation financing and the periods that cases can spend proceeding through courts.

Disappointing Sanne

Sanne Group had a terrible quarter, for which management have to accept responsibility. Having given an upbeat message to the City at their inaugural capital markets event in the spring, the company shocked investors with a profit warning just a few weeks later. A variety of reasons were given, none necessarily recurring.

Sanne took on new staff to run newly won business, then the client delayed the project, leaving people twiddling thumbs on full pay. The Private Clients business went backwards and is now under review. All in all, margins will take a hit in the first half of their financial year, even if overall top line growth remains in double digits.

We’re sticking with Sanne for now because the markets they serve still look very attractive, but execution needs to become more reliable for the company to fulfil its undoubted potential.

Cash producing Shell

Weakness in Shell was caused mainly by on-going oil price volatility amid growing economic jitters. Shell also released disappointing second quarter results which saw profits fall by a quarter, although there were quite a few one-offs that impacted the results, which we don’t expect to repeat.

Cash generation is what we most focus on, for it is cash that funds dividends and loan repayments. The outlook here remains strong and unchanged, underpinning an attractive 6.6% yield; although remember yields are variable and are not a reliable indicator of future income.

Auto Trader & Ideagen well positioned

There was no news of significance from Auto Trader in the period, although news flow from car dealers (Auto Trader’s customers) suggests they are finding life a little tougher of late, with used car sales remaining weak. Time will tell whether this impacts stock listings on Auto Trader’s website, but we aren’t losing much sleep over it. We think it’s almost inevitable that motor dealers will increase their spending on data and e-commerce solutions over time, and we see Auto Trader as well positioned to capitalise.

Full year results from Ideagen were strong, as expected, with earnings per share increasing by 15%. Recently acquired businesses are performing well and demand for its software appears to be holding up well, reflecting the non-discretionary nature of its risk and compliance solutions.