HL Select UK Income shares – one year on

Steve Clayton - Fund Manager

5 March 2018

When we launched the fund, we outlined our aim to provide investors with an attractive level of income today, but more importantly to provide as much potential for long-term dividend growth as possible.

Companies that grow their dividends usually see their shares appreciate over the long-term. In this way a rising income can also translate into long-term capital growth.

One year on, the HL Select UK Income Shares fund has declared monthly dividends totalling 4.024p per unit to holders who bought at launch. This is ahead of our launch target of 3.9p for the fund’s first 12 months.

But this strength of income has not been matched by the overall performance of the fund. Income units, which pay out the dividends received, have lost around 11% in value. In other words, the total return to investors who bought at launch has been -7%. Accumulation units have seen a total return of -7.2%. Over the same period, the stock market has delivered a total return of 0.8%.

Clearly that wasn’t the outcome we hoped for when we launched the fund. What lies behind the performance, and what do the prospects for the fund look like now?

Distinct style

The fund is a fairly concentrated portfolio, typically holding shares in around 30 companies at any moment. That means that each one can make a real impact on performance, good or bad. We invest for the longer term and still hold the large majority of our original positions, reflecting our faith in their prospects.

A concentrated portfolio will often have periods when its performance varies significantly from the wider market. Operating a distinct investment style and process further raises the chance of divergence. Over the longer term, we would hope our focus on cash flow strength and dividend paying potential will lead to significant returns for our investors.

We have only had one holding disappoint on its dividend. That stock was Provident Financial, and the accompanying loss of value on that holding accounts for much of the fall in the fund’s value. We’ve discussed the difficulties faced by Provident Financial in earlier blogs.

When commodities and other cyclical sectors are in favour, as they are presently, we would expect our style to lag behind the wider market. We much prefer to invest in companies with a strong degree of control over their own destiny. In the near term, that has created a headwind of around 2.4% to the fund’s relative performance. But commodity-producing companies can only ever be price takers, not price makers, so whilst their yields can be enticing, we intend to keep exposures low.

Highs and Lows

Some holdings have performed very well. Fidessa, the financial software provider, now the fund’s largest holding, has recently received a takeover offer, at a value some 40% above the position’s book cost.

Ascential, a fast growing information services business has been a big success, and just reported full year results that saw the share price hit new all-time highs. Drinks group, Britvic has been another winning position. Many of our positions have shown profits. But we have seen significant negative impacts to the fund’s relative and absolute performance from half a dozen holdings.

Provident Financial had a 3.0% negative impact on the fund’s value. Imperial Brands shares have struggled, even though the group has continued to grow its dividend by 10% p.a. Imperial cost the fund 1.0%.

Utility shares have been hit by threats to renationalise them, should Labour form a government. Losses on National Grid and Pennon cost a total of 1.2%. Again, both have continued to grow their dividends throughout.

WPP cost the fund 0.6% after it struggled in an increasingly difficult advertising market and Greene King impacted the fund’s relative performance by -0.5% after rising costs squeezed margins.

We have sold our original positions in Provident Financial and WPP because we believe returns in their industries will be lower for the longer term. Advertisers face digital challenges and brands that are increasingly sceptical of the value for money of the ad world’s offerings. Regulation is capping the returns available to lenders of high-cost credit.

We sold out of Playtech too, when it became clear that their market positioning was weakening. Elsewhere though, we have stuck with our holdings, because we see the potential for good income growth in the future and we invest for the long haul.

On the positive side, our technology holdings have added 1.8% to the fund’s relative performance due to Fidessa’s increase in value. Ascential has added 0.9% to the fund’s performance and Britvic added 0.6%. Not holding the heavily indebted Shire Pharmaceutical helped our healthcare exposures deliver 0.5% of positive performance.

Raising growth exposure

We have raised capital from those disposals and trimming of other positions, to invest into some faster growing businesses, which will hopefully generate good earnings and dividend growth in future.

In comes Compass Group, the world’s leading catering business with a hugely cash generative business model that has served investors well for many years. GB Group is a fast-growing IT company that verifies customer ID in e-commerce transactions, raising the fund’s exposure to the digital economy.

Auto Trader and Rightmove dominate the UK’s online listings of vehicles and properties for sale. With no physical stores or print-works, these companies can throw off cash and offer excellent dividend potential. We’ve introduced Just Eat too. Its software connects hungry people to restaurants, taking a share of the takings in the process, leaving the restaurateurs to do the cooking and delivering. Again, hugely cash generative and has grown like Topsy.

New holding Xafinity runs the affairs, but not the investments, of pension funds and has income streams that like the pensioners themselves, are set to run for decades into the future, with excellent dividend potential along the way. Some of these new positions are still quite small, reflecting their lower level of yields. But we expect them to grow their dividends rapidly over the next few years.

As ever, there are no guarantees – the fund could fall as well as rise in value so you could get back less than you put in. Past performance isn’t a guide to the future.

What is the outlook for the fund?

Charlie and I are both investors in the fund, because we’re strong believers in the rewards available from investing in high quality dividend paying companies over the long run. The fund is strongly positioned in technology companies, which should offer attractive growth prospects.

We have big positions in leading consumer products companies, with powerful brands and cash flows. Within our Healthcare exposures, AstraZeneca is breaking new ground with cancer treatments that are winning approval for launch in the vital US market place.

Looking at consensus forecasts, double digit dividend growth is expected from 9 holdings, 5-10% growth from 12 positions, and flat to 5% growth from 10 stocks. Two of these pay their dividends in dollars and currency moves will impact what sterling payment is received. However, yields are not guaranteed and not a reliable indicator of future income.

The largest cash receipts are expected from the holdings in HSBC, Imperial Brands and Paypoint. No single holding is expected to generate more than 7% of the total. The fund will continue to pay monthly dividends.

What are the risks?

We don’t worry too much about Brexit. Mutual interest in trade between the EU and UK should force sanity into the negotiating room, even if it is currently clinging desperately onto the door frame. Brexit aside, domestic politics remains a major unknown.

Interest rates have clearly bottomed both here and across the pond. Further increases are to be expected. But we do not believe they will rise too far, or too fast, because central banks remain nervous of stifling growth. Growth is needed to restore government finances to balance, as the era of QE draws to a close.

Hopefully, our focus on businesses with strong internal growth drivers will provide protection if icy winds do start to blow. Dividends will keep rolling in from our companies, which is one of the best longer term protections an investor can wish for.

Past performance is not a guide to the future. Source: Lipper IM to 02/03/2018.

*Full year performance data not available

Please remember that a dividend declared for any given month is actually paid to investors at the end of the following month. If you hold Accumulation units in the fund, then these dividends are rolled up into the value of your units. That is why the price of Accumulation units is higher than those of Income units in the fund.

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