HL Select UK Income Shares - First Quarter Review

Steve Clayton - Fund Manager

18 April 2019

The first three months of 2019 saw a welcome recovery in the stock market, reversing much of the weakness of late 2018. Economies around the world have generally proved weaker than expected, confounding expectations of higher interest rates later in the year. With yields in bond markets contracting, the attractions of income from shares provided support to markets.

It was, in many ways, the mirror of the previous quarter, which had seen rising bond yields and expectations of higher interest rates in the USA and the UK depressing sentiment and sending share prices lower.

At home of course, the market mood has been much influenced by the course of the Brexit process. As expectations of a hard Brexit receded, domestically oriented shares enjoyed something of a recovery since December. Retailers in particular enjoyed a relief rally after Xmas trading turned out merely to be poor, rather than the utter disaster that had been hyped in the media.

The UK economy has benefited from precautionary stockpiling which has supported the manufacturing and warehousing sectors. We would expect this to unwind in future, which could pose some headwinds to UK economic growth.

The services sector has recently slipped into reverse, as the uncertainties surrounding the course of Brexit continue to swirl. With so many variables at play in the UK currently, near term predictions are even harder than usual.

With the funds’ companies having substantial exposures to international markets we continue to hold the view that the course of Brexit will have relatively little impact upon their long term value. Changes in the value of sterling could be the larger contributor to any impact, as we saw after the referendum.

Fund Performance

Past performance is not a guide to the future. Source: Lipper IM, correct as at 31/3/2019.

The fund registered useful gains in the first quarter, but nevertheless lagged the market by 1.6%. The table below shows the shares that made the biggest contributions, good and bad, to the fund over the quarter:

What pushed the fund forward?

Past performance is not a guide to the future. Source: Bloomberg, 31/12/2018 – 31/3/2019.

Greene King sold plenty of beer and food over Xmas, confounding the market’s worst fears of consumer Armageddon. This appears to have been enough to attract bargain hunters, and perhaps also deter any short sellers from targeting the stock. The resulting 26% rally added 0.81% to your fund’s value.

A good Xmas does not guarantee a happy new year, and challenges remain for the group, not least the rising cost of the National Living Wage. Greene King and many other casual dining firms have had a pretty tough time in the last couple of years as costs rose and consumer incomes were squeezed hard.

The flip side of a higher wage bill is that customers have more to spend. With many in the industry having closed restaurants in response to the squeeze, the pressure on the survivors may have eased a bit, but with confidence fragile, the outlook remains uncertain.

Phoenix Group rallied strongly as it revealed more details on how it expects the acquisition of Standard Life Assurance to unfold. Phoenix believe they struck a hard bargain and that their future cash flows will be greatly enhanced as a result.

Crucially, Standard Life has changed the pattern of Phoenix’s business flows. Now Phoenix has a stream of new business coming in from Standard Life, which will generate future cash flows that can offset the decline in the group’s existing closed books. That augurs well for future dividend prospects, although Phoenix must now prove that they can make the new business sales necessary to turn theory into practice.

We covered Primary Health Properties’ acquisition of MedicX in a previous blog. Suffice it to say that so far, the market has taken the improved dividend prospects that PHP say the deal will generate very positively indeed. Although there are no guarantees.

GB Group delivered a strong performance, outperforming the market by over 6%. Its substantial weighting in the fund, over 4% led to it adding almost 0.6% to the value of the fund.

During the quarter, GB announced the acquisition of IDology, a US firm specialising in electronic ID verification and fraud prevention services. GB had been working with IDology on shared clients for some time, so they were able to be confident that it would be a good fit, especially alongside their Loqate customer location services.

At £233m, this is GB’s largest deal to date and the company part financed the deal with an equity issue, which we participated in. So far, we’re pleased with the outcome; we increased our holdings at 420p per share and the stock is currently trading at over 500p. We recently met with the group and came away reassured that so far, the acquisition is performing as hoped and we remain excited about GB’s long term potential.

Lloyds Banking Group reversed much of the weakness it had shown in the previous quarter. The key event for investors was the announcement of strong full year results, accompanied by a 4.3% increase in the final dividend payment of 2.14p, making a total of 3.21p for the year as a whole.

Results showed the group continuing to generate plenty of surplus capital. A £1.75bn share buy-back programme was announced on top of the dividend increase. At the current share price, this would reduce the number of shares in issue by almost 4%, raising the group’s earnings per share and dividend paying capabilities in future years as a result.

Despite the impact on consumer confidence of the current political furore over Brexit, the group’s bad debts charge remained at low levels, even though the addition of the MBNA credit card portfolio it acquired led to an increase in their absolute level.

What held the fund back?

Past performance is not a guide to the future. Source: Bloomberg, 31/12/2018 – 31/3/2019.

Unsurprisingly in a quarter when the wider market rose strongly, there were some robust individual contributions from many names in the fund. Only a handful of names showed falls in value, but the fund was held back compared to the wider market by not owning mining shares, whose dividends can be volatile, but which nevertheless were amongst the market leaders last quarter.

Even in rising markets, there will always be some stocks that fail to participate. Looking at the list of laggards we can’t say that either of them have committed any great sins.

BCA Marketplace has made no announcements of substance, unless you regard the Chairman giving 2m of her shares to her daughter for free as such. Certainly, one has to assume that young Ms. Palmer-Baunack regarded it so, but it hardly counts as a reason for the shares to decline by 10% in the quarter.

Sentiment surrounding the automotive sector is depressed, with manufacturers reporting tough conditions. But BCA is not exposed to new car sales, just the buying and selling of second hand vehicles and associated services. Their most recent trading update, back in November was most encouraging, we felt.

Sanne Group had a volatile start to the year, falling sharply after announcing that the Chief Executive was retiring, even though he appeared to have only just grown out of his school uniform (he’s 42).

We met up with Dean Godwin, the retiring CEO, his successor Martin Schnaier and James Ireland, Finance Director. We’re happy that Dean’s decision was an entirely personal one, and that Mr Schnaier, previously the Chief Operating Officer is a strong replacement. Their interim results showed the group reporting double-digit organic growth and we think the opportunities in front of Sanne look exciting. We expect it to report strong growth for many years to come.

XPS Pensions have made no announcements since late November, other than a change of non-executive director. So the stock’s performance looks odd. We confess to feeling a little apprehensive currently, for the company took part in a major merger a little over a year ago, and revealed slightly underwhelming progress when they reported their interim results.

On the face of it, XPS looks like an attractive growth story, supporting pension fund clients that will be around for decades. But we suspect that the market is going to remain sceptical on XPS’s ability to convert its opportunities into profit until it has demonstrated that the Punter Southall deal is delivering to plan and that top line growth is accelerating.

Past performance is not a guide to the future. Source: Lipper IM to 31/3/2019. Full year data prior to March 2017 is not available.

We are also launching the new HL Select Global Growth Shares fund to provide further global diversification for Investors. You can find out more about it here.