HL Select UK Income Shares - Q1 2023 Review

James Jamieson - Fund Manager

9 May 2023

Market review

The first three months of 2023 posted another positive result, with UK Equities up 3.1% to 31 March. However, the direction of travel over the quarter was by no means a straight line. January and February were characterised by a continuation of the trends seen late last year, with a 'dash for trash,' for want of a better expression. Then, the mini financial crisis erupted in March which prompted markets to adopt a more defensive stance.

From our HL Select perspective, the problems faced by Silicon Valley Bank and the other regional/specialist lenders in the US are specific to them. The same can be said of Credit Suisse, although their woes potentially have far greater systemic implications. We are confident that major UK banks are relatively well capitalised. However, these events nonetheless serve as an important reminder of the painful consequences that tighter monetary policy can bring. More on this in the Outlook.

Hard macroeconomic data is still coming through better than expected, with demand having remained remarkably resilient. This was the case on both the industrial and consumer fronts, which explains why capital goods have led the industrials' outperformance over the period, as well as the relative strength of the consumer discretionary sector. In contrast, miners were the weakest sector, with their cyclical nature counting against them as recession worries mounted.

A relatively mild winter helped keep gas prices lower than had seemed likely, easing inflationary pressure, which also helped sustain demand. But inflation remains in double digits, and central banks have continued to raise interest rates and reassert their commitment to continue doing so. These actions will inevitably cause economic pain, but inflation is considered the greater evil. Indeed, inflation remains the main topic determining asset prices, and the market seems totally disinterested by the ongoing conflicts and trade disputes. Concerns to highlight include Russia building out nuclear infrastructure in Belarus and China's more hawkish post-COVID foreign policy.

Fund review

The portfolio returned -0.3%* in the quarter. As you would expect given the market dynamics explained above, we incurred softness at the start of the year which gave way to a pick up as the period progressed. However Financials, an area from where the fund, and indeed the market, generates much of its income, were hard hit by the Banking scare. We do not expect the failure of Silicon Valley Bank, nor the near-collapse of Credit Suisse to have any impact on the fund’s dividends.

Sector contributions were mainly driven by individual stocks within those sectors, rather than being due to industry-wide trends. Industrials came out top due to RELX. Energy was a key contributor thanks to BP. Consumer Staples were a drag due to British American Tobacco, as were the Financials due to Close Brothers and Phoenix. All of these are discussed in more detail below.

Total Return (%): Fund v Index v Peers

Past performance is not a guide to the future. *Source: Morningstar Direct to 31/03/23

Stocks review

Winners

RELX is, we feel, an excellent company that has continued to execute on their strategy. The key appeal has been dependability and they have delivered stable growth and returns, but for some time we have been observing an acceleration in the Risk and Legal divisions, alongside a post-COVID recovery in Events. This recovery came through in February’s full year results. RELX offers investors a progressive dividend policy, backed by attractive growth and the return of additional capital to shareholders by means of a new share buyback. Earnings forecasts were upgraded, helping the stock to perform well in the quarter.

Next is in the top table again. The share price this quarter is a function of the surprisingly robust consumer data that has continued to come through in the UK, rather than any developments specific to the company. We won’t evangelize their merits this time around although it’s worth noting that a trading statement at the end of March highlighted a more challenging outlook, which we struggle to disagree with.

BP had a very strange quarter. The full year update in early February resulted in a strong rally as the company raised their oil price assumptions and upgraded medium-term earnings. With capital expenditures contained, whilst not guaranteed, we feel this bodes very well for even greater cash returns to shareholders. However, these positives were wiped away by recessionary fears when the banking issues began. So the gains were given up, only to stage another rally into quarter end. We aspire to look through market noise and focus on intrinsic value. With energy prices looking well supported, we continue to see such value in BP.

National Grid had a very quiet quarter but was a beneficiary of investor’s search for reliability that came through in the wake of the banking debacle. With attractive regulated asset growth backed by renewables investment in both the UK and US, in our view, the shares still appear undervalued.

Schroders put out their full year results in March which although satisfactory, contained soft flows and higher costs. The shares responded accordingly, but this was reversed in March. It may seem counterintuitive to read of a Financial company performing well at this time. But Diversified Financials such as Schroders are relatively less affected by the interest rate issues that impact Banks and Insurers more heavily.

Past performance is not a guide to the future. Source: Bloomberg (01/01/23 – 31/03/23)

Losers

British American Tobacco was partially afflicted by poor performance among Consumer Staples, but various company-specific negatives weighed on the shares. Recall that while the legacy business produces very strong profitability and cashflows, it is the next generation products that serve as a driver of perceived future value and are important to investor sentiment. So, the weakness is no surprise given negative rulings on both legal and regulatory issues concerning their vaping franchise, alongside a loss of share in the key US combustibles market. The company has chosen to prioritise paying down debts over and above buying back stock. While we think this is the right thing to do in the current climate, the announcement disappointed investors and removed a support. The operational delivery has been unsatisfactory and we are appraising how persistent these changes might be.

Close Brothers has incurred a perfect storm across its three divisions. The trading business has been impacted by low volumes, an issue beyond their control. The wealth management business has incurred poor performance – this periodically happens. It is the underperformance of the banking business that exercises us given Close Bros.’ high-quality, counter-cyclical model is the main appeal to own the company. In summary, they acquired a non-core specialist lender called Novitas a few years ago, that has been written down after its lending decisions were found to be poor. While there could be writebacks, the events raise questions about operational management and capital allocation decisions. Our work suggests that the incident is isolated, but we continue to review closely.

Experian has little in the way of obvious reasons for the quarter’s performance. Our work suggests they are seeing stronger competition in some parts of the US business, so perhaps other investors are responding to the same findings. An update early in the quarter was very much in line with expectations.

Primary Health Properties remains in the losers’ camp with no change to the reasons for this or our view on the holding. Net Asset Values could fall further but look to be well discounted and their cashflows, which support dividends remain some of the most assured we know. The insurer Legal and General (also owned) declared a 4% stake in the company and given their need to match long-term liabilities against cashflows, they presumably agree. Results in February beat estimates and an attractive deal was done in Ireland which opens up a long development pipeline there.

Phoenix is seeing good operating momentum and updated the market to that effect. The blowout in credit spreads (the risk premium ascribed to corporate bonds compared to government bonds) brought about by the banking scare, hurt those with high exposure to these assets. Phoenix is one of these but the point to note is that not all investment portfolios are equal and our analysis leaves us very comfortable that credit risks are limited in their case.

Past performance is not a guide to the future. Source: Bloomberg (01/01/23 – 31/03/23)

The outlook

As conveyed at the last update, we anticipate low visibility and elevated volatility in 2023, and this view remains. Trading activity in the portfolio has been focused on building out diversification in under exposed areas. The addition of HSBC and Croda speak to this and have a common theme, pro-cyclical businesses that have embedded resilience. The individual rationales on each can be found on the website. Ascential was the only exit, with reappraisal concluding that the valuation is uncompelling given what we see as an increasing vulnerability to competition.

The mini financial crisis that saw bank failures in the US and the forced acquisition of Credit Suisse by UBS was the big story of the past period. As touched on in the Market Review, the events are an important reminder of what happens under a tighter monetary regime. So from our perspective these forces are unlikely to be contained to the first quarter, not least because we see banks being more reluctant to lend. Precisely how and when these forces present in the future we do not know, although the hit to sentiment can only exacerbate those tighter credit conditions and ultimately accelerate the downturn to come. In other words, the starting gun has been fired.

Central Banks are now between a rock and a very hard place. Inflation remains persistent but the travails of the banking sector means that the growth outlook appears increasingly challenged. The big question is now whether these policy makers remain true to their pledges and enact further tightening, even when economic prosperity visibly worsens. Equity markets seem likely to remain rather unpredictable until a clearer view of the growth outlook, good or bad, is established.

With investors more alert to the potential for pain ahead, Q1‘23 corporate results and especially the outlook statements from management are likely to set the tone for markets in the current quarter.