HL Select UK Income Shares Q2 2020 Review

Steve Clayton - Fund Manager

10 July 2020

Market Review

Hopes that the pandemic was easing led to a strong recovery in stock markets around the world. The UK was no exception, with the FTSE All Share index returning 10.2% over the quarter. Not everything went up; Energy shares and Banks were notable laggards, both sectors losing about 8%. Amongst the winners, Miners raced ahead by almost 29% and General Retailers by 28%.

Broadly speaking, what went down in Q1 saw a bounce in Q2 as it became clearer that the impacts of the pandemic were unlikely to see the worst-case scenarios unfold. Banks failed to participate however due to concerns over bad debts and a squeeze on interest margins following emergency rate cuts on both sides of the Atlantic. Energy shares were dragged lower by Shell’s momentous decision to cut its dividend and a failure of oil prices to recover to previous levels.

A notable feature of markets globally this year has been investors’ preference for “Growth” shares over “Value”. The digital economy is far more heavily represented in the former category than the latter. With untold millions working from home, communicating via video conferences over the internet and ordering their shopping online, this is perhaps understandable. But trends can only carry on if the fundamentals justify. As valuations rise, Growth stocks will need to deliver the superior earnings that investors are paying these higher prices for.

Performance Review

The fund delivered a total return of 7.0% over the quarter, compared to the FTSE All Share return of 10.2%. The fund’s return was driven by positive returns in Consumer stocks, which added almost 1.7% to the fund’s value, a 1.4% contribution from our Healthcare holdings, 1.2% from Industrials and 1.4% from our Real Estate holdings. The only negative sector return came from our positions in the Energy sector, which subtracted 0.7% of value from the fund. Broadly speaking the fund’s gains were below those of the market in Q2 due to our underweight Materials position in a period when the sector rose sharply and an overweight position in Financials, which lagged the wider market during the quarter.

Over the year to 30 June 2020 the fund delivered a total return of -9.0% compared to the FTSE All Share return of -13.0%.

Past performance isn’t a guide to the future. Source: Lipper IM 30/06/2015 to 30/06/2020.

N/A = performance for this time period is not available.

Past performance is not a guide to future returns.

Significant Winners and Losers in Q2 2020

Winners

Past performance is not a guide to the future. Source: Bloomberg (31/03/2020 – 30/06/2020)

Our best contribution in the quarter came from Tritax Big Box, where a 31% gain in the stock added 1.4% to the fund’s value. Tritax shares recovered after a weak start to the year, driven by fears that tenants might not make their rental payments. With major food retailers and household names in the portfolio, and Amazon as the largest tenant we do not expect a significant problem with rents. During the quarter Amazon signed up for a massive 2.3 million square feet development at Tritax’s Littlebrook site close to the M25 at Dartford.

Both Legal & General and AstraZeneca added around 0.75% to the fund’s value, and both made a point of sticking to their dividend policy and paid out significant dividends to shareholders in the quarter. AstraZeneca is one of the leading Coronavirus vaccine developers, working in partnership with a team at Oxford University. Sentiment here cannot have hurt, but the group also reported some encouraging clinical trial results during the period too .

Legal & General took flak for paying their dividend when others were cutting. But the group stuck to its guns, highlighting their financial strength and as the quarter moved on, the recovery in asset markets underpinned this, helping the stock to rally.

Ascential and GB Group both performed strongly in the quarter. The latter released an encouraging trading update whilst Ascential recovered as the market reckoned that whilst their events business might be hit hard, their e-commerce facing activities should benefit from the increased online activity seen since the pandemic broke.

Paypoint added 0.5% to the fund’s value with its 13% recovery in price after being initially hard hit by unfounded concerns that consumers might be offered payment holidays by utility companies. Paypoint’s terminals in convenience stores allow consumers with pre-payment meters to top up their gas and electricity accounts, earning fees in the process.

Persimmon recovered by 19% as fears over the state of the housing market abated and the company reported robust forward sales and a return to activity on sites. The group has cash in the bank and did not access government support so should have little impediment to resuming cash returns to shareholders once the trading environment has normalised.

Losers

Past performance is not a guide to the future. Source: Bloomberg (31/03/2020 – 30/06/2020)

Energy companies struggled in Q2. Shell announced its first cut to the dividend since WW2 , and whilst BP paid its dividend for Q1 , there is real doubt about the level that will be paid going forwards. The pandemic led to a slump in demand for energy and transport fuels in particular as planes stayed on the ground, cars in their garages. The economy is gradually reopening, but energy prices remain at depressed levels. Both BP and Shell have announced that they will take multi-billion write-downs on the value of their assets, reflecting the lower cash flows expected in today’s lower energy price environment.

Longer term demand for energy appears robust and future prices are expected to be above current levels, with most producers forecasting longer term levels of $55 per barrel and higher. Of course, none of them forecast oil prices of $40, let alone that prices would briefly turn negative. On balance, we felt that the levels seen in Q2 understated the value within the higher quality assets we see in Shell’s portfolio and we added to our holding.

Banking shares have struggled since the pandemic broke out. With unemployment rising at a historic pace, bad debts from citizens and businesses alike are likely. Commercial real estate holds particular risk, with retailers missing rental payments at unprecedented scale . Landlords are likely to be having some fairly frank conversations with their bankers. In the UK, the regulator has prohibited banks from paying dividends to shareholders whilst the impact of the pandemic is assessed. Banks’ customers are benefiting from government support schemes and banks themselves are offering repayment holidays to millions. The government has rightly decided that whilst the State is acting to reduce bad debt risks for the banks, they should play their part by retaining as much capital as possible.

We took advantage of weakness in Close Brothers to add to our holding. Their balance sheet is strong and their specialist lending activities are lower risk, with little exposure to commercial property or sub-prime borrowers. Historically they have shielded their capital well during downturns, to emerge stronger, able to grow rapidly whilst others are still licking their wounds. We expect Close Brothers to return to paying dividends at the earliest opportunity.

We funded our increased position in Close Brothers through reducing HSBC. Slower economic growth around the world seems likely and HSBC’s focus on financing Chinese trade has left them exposed to the deterioration in trade relations with the USA. The desire to rebalance the trading relationship seems equally strong amongst Democrats as Republicans, so the upcoming Presidential election may offer little chance of any thawing between the two sides. Depressed levels of trade will make it hard for HSBC to achieve the income growth it so badly needs to rebuild returns on equity.

You can see every holding in the portfolio and find out why it was chosen, on the portfolio breakdown page.