HL Select UK Income Shares - New Monthly Review

Steve Clayton - Fund Manager

14 February 2019

So far this quarter, the UK stock market has been staging something of a recovery after the weakness of late 2018. The market bottomed just after Christmas Day and since then (at time of writing on 13 February) it has recovered by over 9%. Early days of trading in the New Year saw some pretty sharp rotations, with strong recoveries in some of the weakest performers of the previous months, and vice-versa.

In itself, this isn’t that unusual. We often see “bargain hunters” in the market, especially at the start of the year, looking to pick up stocks that have recently had a bit of a tumble. That can be enough to turn the stock around in the short term, but in the long run the business has to deliver to support a strong share price. Our experience is that often, “bombed-out” stocks are actually not yet fully detonated and must be treated with great care, ideally from a distance.

A much-hyped Apocalypse On The High Street turned out to be a tough, but survivable Christmas for most retailers and with worst fears not realised, retailing stocks have enjoyed a rally of around 15% so far this year. At the opposite end of the scale, Vodafone revealed tough trading in its European businesses sending the mobile telephony sector down almost 10%.

New Blog Format

We’ve decided to change how we write about the funds, to try and make our blogs more relevant and engaging. Once a quarter, we’ll review performance of the portfolios so you can see what the main driving forces have been. In between the quarterly reviews we’ll be writing in more depth about the stocks we hold in the funds and the changes we make to the portfolios.

We hope you find the blogs interesting and please remember that you can check on the performance of your funds at any time on our website.

Stock Spotlight: Tritax Big Box and Primary Heath Properties

It’s been a while since there’s been much to say about either of the fund’s real estate companies, but like buses, they have both come along with big news at once. Primary Health Properties (PHP) has announced a merger with smaller rival MedicX and Tritax Big Box has acquired the development group DB Symmetry. Both deals bring greater scale to the acquirer, but the nature of the deals is otherwise rather different.

MedicX undertook a very similar trade to PHP. It bought and sometimes developed from scratch, modern, multi-disciplinary healthcare facilities. Its portfolio is spread across the UK, with some exposure to Ireland too. Both firms get 90% of their rents from the NHS or its Irish counterpart and both have let their properties via long-term leases and structured a big slice of their borrowings to deliver predictable funding costs for many years to come.

The addition of the MedicX assets will see PHP save around £4m a year of management fees and operating costs, and should also facilitate a reduction in financing costs when existing debts mature. The deal was struck at a small premium to MedicX asset value, but we expect significant accretion to PHP’s earnings per share over time, raising the dividend growth potential.

PHP has of course delivered over 20 consecutive years of dividend growth, earning its place in the HL Select UK Income Shares fund on the back of that, although this performance is not guaranteed to continue. So PHP is scaling up to do more of the same, but squeezing extra efficiencies out of the enlarged portfolio.

Tritax Big Box is moving further upstream with the DB Symmetry deal. Tritax was originally a vehicle to acquire giant distribution centres, whose values were underpinned by strong demand from investors and occupiers alike.

Along the way it began to fund the development of pre-let new build Big Boxes and quickly became the dominant investor into very large distribution and e-commerce facilities. More recently the group has begun investing into land, in order to develop additional facilities, with its largest deal being the acquisition of 124 acres of development land next to the M25 on the site of the former Littlebrook power station near Dartford.

DB Symmetry is a team of property developers who were previously backed by Delancey. Their vehicle has acquired a vast estate of strategic land upon which they will seek to obtain planning permission to develop Big Box facilities. Some are already under construction, but most will work their way through planning in future years. Development will typically only proceed once an asset is pre-let. If as Tritax expects, the DBS portfolio can all achieve planning permission, then Tritax’s portfolio could be doubled in size.

Both these deals look good to us. Both raise the future dividend potential of our holdings and both look to have been structured in a way that limits risks to the acquirer. Demand for healthcare facilities and super-scale distribution is unlikely to fade away and the long leases that PHP and Tritax can strike, hopefully support dividend payments far into the future.

Stock Spotlight - Sanne Group

Sanne Group provide fund administration services, typically to real estate investors, private equity firms or hedge funds. A recent trading statement saw the stock tumbling sharply, even though the group said they had seen strong performance and record new business. As always, the devil was in the detail. The overall result looks on track, but Sanne have reached the finishing post, despite their divisions running at very different speeds.

In the fast lane, Europe and Asia Pacific beat expectations, the USA continued to run at pace, and their Mauritian business accelerated as hoped. But South Africa has been tough and their division that services Private Clients has struggled (and failed) to stand still.

Overall, the group seems to have delivered better than expected revenue, but after a period of rapid growth both organic and acquired, the group needs to invest into its infrastructure to support future expansion. This has eaten into profit margins, leaving the overall profit performance in-line.

At the same time, Sanne announced the retirement of CEO Dean Godwin. Dean is 43. Markets don’t like unwelcome surprises and few were expecting Dean to hang up the reins anytime soon. The combination of a margin squeeze, a struggling (albeit minor) division and the unexpectedly early departure of the man seen as the architect of the group’s growth unnerved the market. In the days following the news, the shares dropped by almost 20%, before mounting something of a recovery.

Full details will only become available once the annual results are published in a few weeks’ time but it’s clear that Sanne has been suffering a degree of growing pains. The industry in which Sanne operates starts from a position of fragmentation with many smaller players. Despite this, there are scale benefits that can accrue to larger operators. Sanne had sought to be the consolidator that achieved that scale. A spree of deals in recent years left it needing to unify and simplify its infrastructure, whilst some management change was also required to cope with the increased scale of the group.

The underlying growth potential of the group appears undiminished, but the profit margins that Sanne will attain will no doubt be a degree lower than had been hoped in the near term. We like what Sanne does; revenues have tended to recur, because funds rarely change their administrators. Little capital needs to be deployed, for this is a know-how business, not heavy industry.

We are disappointed though to see the pace of change in the boardroom, with the original CFO from the time of listing already having departed. The new CEO has come from within, having joined in 2011 and most recently acting as Chief Commercial Officer. His first task will be to convince investors that Sanne can move through the current issues and return to a more consistent growth tack.