HL Select UK Income Shares - Q2 2022 Review

Steve Clayton - Fund Manager

1 August 2022

Market review

Inflation, interest rates, war and recession dominated sentiment in the second quarter, and markets dropped sharply. The UK stock market delivered a total return of minus 5.0% over the period. Bucking the trend, tobacco stocks performed strongly, along with pharmaceuticals and defence companies. Banks and energy producers eked out minor gains, but at the opposite end of the scale, there were significant setbacks for automotive, industrial transportation and mining stocks.

Investors are concerned that the current strength of inflation, as much a global concern as a local one, will drive interest rates higher. This is being exacerbated by the war in Ukraine, on top of pandemic-induced supply chain disruption. UK inflation is especially pronounced, with the latest reported CPI rate of 9.1% far above the Bank of England's targeted rate of 2.0%. Sterling has weakened in response, dropping from an end-March level of $1.31 to $1.21 at quarter-end. This will further exacerbate the situation since significant imports like energy tend to be priced in US dollars.

The outlook here is unusually uncertain. On the one hand, the supply chain disruptions and other pandemic impacts ought to fade over time. Indeed the war in Ukraine exacerbated the situation, injecting a new urgency to food price inflation, but wheat, which surged almost 100% on the invasion, is now back close to its end-year level. Likewise, lumber prices, which had been driven up from around $300 per tonne to over $1,600 as economies began reopening, have now retreated to around the $700 level. What is unknown however is the degree to which labour prices will rise.

The labour shortages, from lorry drivers to bar staff, have been well reported, even if their origins are less clear-cut. Brexit may have contributed, but the UK has been far from alone in experiencing labour shortages. Either way, the degree to which wages rise will impact future price rises. Central banks fear allowing a wage/price spiral to develop. They also fear triggering recessions that undo the benefit of pandemic support packages. It is a delicate balance to strike.

It is improbable that supply chains cannot be repaired. They may well be reconfigured, given the increased desirability of manufacturing close to end markets. So we see longer-term constraints over the availability of goods and services as unlikely. But their cost is much more subjective. How quickly economies respond to rising rates will be critical. The faster they do, the less interest rates will need to rise.

Longer-term, the challenges and opportunities abound. We are only at the start of the digitisation process, and technologies like artificial intelligence have barely begun. The energy transition lies ahead, and there seem likely to be some near-term inflationary consequences. But ultimately, replacing fossil fuels with renewable energy suggests lower long-term energy costs, which ought to bode well for investor returns.

Q2 2022 Fund Performance Review: HL Select UK Income Shares

The fund delivered a loss in the quarter of 3.6%* compared to the 5.0% market loss. The most significant positive contributions to the fund's value came from EMIS, a healthcare technology company which agreed to be acquired by a larger American healthcare enterprise at a substantial premium. Elsewhere, we saw gains from a return to favour by the tobacco sector and a move to unify the share capital of Schroders, which benefited our holding of non-voting shares.

Detractors came in the shape of Tritax Big Box, where news from Amazon knocked sentiment. GB Group, Ascential and Close Brothers also proved a drag, likewise Diageo. We go on to discuss the drivers of these below.

Past performance is not a guide to the future. *Source: Lipper IM to 30/06/2022

Significant winners and losers

Winners

Past performance is not a guide to the future. Source: Bloomberg (31/03/2022 – 30/06/2022)

We shall miss EMIS Group, but money talks. The group received a takeover approach from Optum UK, a subsidiary of UnitedHealth Group Inc at a price of 1925p, far above the market price and comparing very favourably to our average cost of around 1033p. This valued EMIS at about US$1.5bn, which leaves us scratching our heads as to why UnitedHealth bothered, for they are valued at around 300x that much, so EMIS will hardly move their dial. But then again, EMIS can open the doors to a lot of hospitals and surgeries, pharmacies and clinics, enabling the selling of the wider UnitedHealth offering. Importantly, EMIS-X was always seen by the group as creating the critical data platform to enable data insights and sharing for an era of connected healthcare. So maybe the deal was more about buying an address book than a health software creator. Either way, it may be a while before the little village of Egton, North Yorkshire (being the E in EMIS), produces anything else worth US$1.5bn.

Tobacco shares have been out of favour for some time but have recently enjoyed a period of improved sentiment. British American Tobacco's announcement of a share buy-back programme has now translated into regular repurchases of stock in the market, which may be helping to provide support. Sentiment was also boosted by the news of a bid for Swedish Match, by Phillip Morris, showing ongoing faith by the industry in the underlying value of nicotine markets around the world.

Both the UK's top-tier pharmaceutical stocks rose during the quarter. GSK is progressing toward its demerger of Haleon, the group's consumer healthcare division, which it claims is worth demonstrably more than $50bn, otherwise, it would presumably have accepted Unilever's offer of that much in cash last quarter. AstraZeneca has been reporting ongoing, largely positive news from its clinical trials programme, raising the potential for growing existing product revenue streams and creating new ones. Nothing looked like a game-changer for the business, hence the rise was limited to single digits.

We bought into the non-voting shares of Schroders plc late last year, arguing that this was a well-run business where the founding family had sufficient skin in the game to ensure that remained so. The discount attached to the non-voters was too wide in our eyes, given both voters and non-voters received the same dividend per share. During the quarter, Schroders announced the unification of the two classes of share, prompting a sharp jump in the non-voters' price. We still view Schroders as a strong business, but it is not as cheap as it once was given that leap up in price.

Losers

Past performance is not a guide to the future. Source: Bloomberg (31/03/2022 – 30/06/2022)

Tritax Big Box REIT has been one of the fund's most successful investments to date but gave back some ground this quarter. We see two causes. Amazon is their most prominent tenant, and their announcement of a hiatus in estate growth somewhat dampens their demand for space. But it does not impact the leases they have signed already. Secondly, we have seen interest rates and bond yields pick up. This could eventually lead to weaker demand from investors for commercial properties at current market yields. Both can impact Tritax's valuation in terms of its owned property portfolio and the stock itself. We reduced our position in the stock some months ago, given property valuations were high. But tenant demand for Distribution assets remains well in excess of supply, whilst higher inflation tends to boost the income from assets with CPI-linked rents in the portfolio.

Ascential had the second-largest negative impact on the fund during the quarter. On the positive side, the group revealed it was contemplating whether its digital assets should be listed in the US, where they might attract a stronger valuation. On the negative side however, there was the risk that anything gained on Wall Street could be lost back home if the non-digital assets were to be de-rated. But we think the main headwind for the stock was the news from Amazon. That could portend a slowdown or reduction in demand for Ascential's services to brands, where it helps them to maximise revenues across the Amazon platform.

Amazon's messaging knocked confidence in tech-led growth more widely, and GB Group's exposure to e-commerce worked against it during the quarter. GB Group's e-commerce exposure is meaningful, but they have seen no slowing of demand, as evidenced in their recent full-year results that showed double-digit organic growth in revenues. Indeed their acquisition of Acuant has raised the structural growth rate of the portfolio, we believe.

Fears over global growth, not least in China, where authorities continue trying to impose zero-covid policies, saw weakness in physical commodities and expectations for future pricing, which weighed heavily on the prices of mining companies, including Rio Tinto. The price of their output will always be driven by the global supply/demand balance, however, we believe their cash generation will be reliably strong because of the low cost of supply they enjoy from their key Western Australian iron ore reserves.

Close Brothers suffered from the perceived cyclicality of banks at a time when economic sentiment was souring, along with slower trading at its market-making division, Winterflood. No one should have been surprised at the latter, the pandemic ushered in an extraordinary wave of consumer share dealing that could not be continued once workers started returning to their regular places of work. Underlying growth in the banking business has been sound and margins strong. The group was amongst the first banks to resume dividend payments, and, barring any further industry-wide interventions by the PRA, we see Close Bros.' dividend as one of the most reliable in the portfolio.

Fund Manager Appointment

James Jamieson has joined the Select team to co-manage our UK funds. James has many years of experience gained in major investment businesses, most recently at RBC Global Asset Managers, where he ran pan-European Equity portfolios. James brings new valuation skills to the team and a thoughtful risk management approach. We look forward to seeing him driving the funds' performance ahead in future years.