HL Select UK Income Shares Q3 2020 Review

Steve Clayton - Fund Manager

14 October 2020

Market Review

The FTSE All Share index lost 2.9% (total return) during the third quarter as the market recovery of the previous quarter ran out of steam. The quarter was characterised by relatively small rallies and repeated fades as sentiment was tugged in opposing directions.

With economies at home and abroad suffering sharp contractions as nations locked down, investors were scanning for signs of recovery with each passing month. The evidence is mixed. Millions of workers remain on job support schemes, which will eventually end. Massive amounts of stimulus have been lavished by governments around the world. Gauging the underlying position is challenging.

But economies are definitely stronger than they were, and in our view, stronger than might have seemed likely a few months ago. So far, stimulus has proven effective. Of course challenges remain, not least the weaning of companies and employees off job support schemes. This will not always end well, but some businesses will reabsorb most, if not all of their former staff.

So a base is being built, and the questions are shifting toward what growth rates may be seen in the years ahead. During Q3 the market anticipated a stronger consumer, pushing retail shares higher. Stimulus measures augur an increase in physical investment, which drove mining stocks forward. On the flip side, confidence in the outlook for energy companies and banks ebbed, sending those sectors lower. Lower energy prices directly impact energy companies’ cash flows. For banks, ultra-low interest rates are now seen persisting for some time, limiting their ability to earn attractive interest rate margins.

Events in the UK market, and indeed almost everywhere else, were largely eclipsed by an extraordinary recovery in US technology stocks, with the US Nasdaq index rising to new highs, as the market bets on the digital economy outperforming traditional business models for years to come.

Performance Review

The fund delivered a total return of -3.3% in Q3, which compared to the FTSE All Share Index total return of -2.9%. The main drivers behind the fund’s performance in the quarter were a drag from our lack of exposure to mining shares, offset by strong performances by our holdings in financial stocks. Paypoint revealed a regulatory challenge on the last day of the quarter, costing the fund more than 0.6%% of its value as the stock dropped.

Over the year to 30 September 2020 the fund delivered a total return of -11.4% compared to the FTSE All Share Index return of -16.6%.

Past performance isn’t a guide to the future. Source: Lipper IM 30/09/2015 to 30/09/2020.

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

We discuss some of these movements and other notable portfolio movers below:

Significant Winners and Losers in Q3 2020

Winners

Past performance is not a guide to the future. Source: Bloomberg (30/06/2020 – 30/09/2020)

Unilever was a significant positive contributor this quarter after reporting a resilient half year earnings performance and unchanged quarterly dividend. Unilever is very used to managing through crises, given its significant exposure to emerging markets, which tend to be prone to periodic bouts of instability. This, combined with the strength of Unilever’s balance sheet and cash flows means it is well placed to emerge from this crisis stronger, with scope to gain market share from weaker rivals.

Next’s half year results were very Next-like. The financial performance was extremely resilient in the circumstances, with the business eking out a small profit in the 6 months to the end of July despite the closure of Retail stores and disruption to warehouse operations during the period. Even more impressively, the business gushed cash, resulting in a £350m reduction in net financial debt.

This robust financial position is allowing Next to continue investing in its business, at a time when many competitors (e.g. New Look, Debenhams) are in serious trouble and can only think of survival. A particularly exciting Next initiative is Total Platform. This allows third party brands to partner with Next, tapping into its online logistics and distribution network. The appeal of a service like this is it allows brands to focus on what they are good at, namely branding and design; while leaving Next to handle the unglamorous but essential guts and guttering of running an online business, like warehousing and returns.

Adobe is the leader in Creative software and Digital Marketing. Several areas of its business have seen increased demand during the crisis. The shift to remote working for example has driven a surge in demand for digital documents, with use of web-based PDF services up nearly 40% in Q2, and cloud-based electronic signature usage increasing 175% since the start of the fiscal year. With every business likely to think harder about how they engage digitally with customers, we believe the future looks bright for Adobe.

Incremental investment requirements for Next are fairly limited, because it’s spent two decades building out and refining its online platform. Next can charge a commission on partner brand sales; so this has scope to build into a lucrative profit stream over time. To us, Next is a classic example of a strong business getting stronger during this pandemic.

Phoenix has been a solid performer for the fund since we bought it a couple of years ago. Its dividend has grown and the business has executed significant acquisitions along the way. Its latest deal, the purchase of Re-Assure is expected to fund further dividend growth and cash generation in the years ahead. Toward the end of the quarter we took profits on a portion of our holding in Phoenix to begin building a position in another stock that we expect will be a major beneficiary of an eventual return to a post-pandemic society. We’ll say more, once we’ve completed our dealings.

Tritax Big Box had a good quarter, rising by 8%. Tritax continues to pay regular quarterly dividends and its tenants have continued to pay their rents, reflecting the critical nature of distribution centres to their tenants. We saw the first disposals from the portfolio during the quarter, at levels ahead of the most recent valuations, providing reassurance in the quality of Tritax’s assets. The funds released will enable the company to acquire and develop new assets, especially within their Tritax Symmetry development division.

Losers

Past performance is not a guide to the future. Source: Bloomberg (30/06/2020 – 30/09/2020)

BP and Royal Dutch Shell both had a tough Q3. Oil prices remained low and BP followed Shell’s action of the previous quarter, cutting its dividend. Energy companies are deeply out of favour. Transport activity, especially aviation has been hit hard, lowering demand for fuel. Oil prices have remained depressed, even if we did not see a repeat of the shenanigans of Q2, when prices briefly turned negative. The world desires a greener future and energy producers are trying to cut the carbon intensity of their output. Right now investors are sceptical, but the energy transition will be long and drawn out, requiring substantial hydrocarbon production for some time to come. So it may be too soon to write off the oil majors just yet.

Paypoint shares did very little until the last day of the quarter, when they revealed that the regulator Ofgem had written to them, raising potential objections to the nature of the exclusive arrangements Paypoint have with utilities to allow customers to pay their bills via the Paypoint network located in independent retailers. The shares dropped sharply to end the quarter 15% down. The matter is now open for consultation and review and we await further news. We were surprised by Ofgem’s actions. The contracts enable the network to exist and create the ability for consumers to pay for key services at convenient locations nationwide.

Both GlaxoSmithkline and Legal & General had lacklustre performance over the quarter. Perhaps GSK suffered from being out of the limelight whilst its peer AstraZeneca had the benefit of positive clinical trial results, regulatory approvals and its role in the Oxford Covid-19 vaccine project. Either way it dipped by 10% in the quarter, without good reason that we could see. Likewise, L&G delivered respectable enough results, and paid its dividend but still gave up 13% in the quarter. L&G’s challenge moving forward is to show that it can fund its growth objectives whilst still leaving capital free for funding a progressive dividend.

Relx was a little weak following its first half results, which to us contained little in the way of surprises with weakness in Exhibitions and print books, and resilience in electronic and digital revenue streams. Cash generation was very strong and the dividend was held underpinning a current yield of around 2.5%.

Outlook and Dividend

We raised the monthly payment to 0.25p per income unit in August, which will be the base level for at least the next few months. The dividend for September, paid to investors in late October has been set at 0.586p per income share. The September dividend is the final dividend for the fund’s financial year and consists of all the income available for distribution that the fund has not already paid out in the preceding eleven months. Please remember all dividends are variable and not guaranteed. Past income paid, is not a reliable guide to the income you’ll receive in future.

This makes a total payout for the financial year to 30 September 2020 of 3.438p, a reduction of 16% from last year’s total. To put this in context, almost half of the UK’s major companies scrapped or cut their dividend payments following the pandemic outbreak. For the new financial year, we see a degree of push-me-pull-you in the outlook for the fund’s income. We have some new holdings, like Next, EMIS and Persimmon that have not made much contribution to the fund’s income this year, but will pay a full year’s worth of dividends in FY21. On the other hand, companies that cut half way through the year will be paying at the lower rate for the whole of the year. We will provide updates on the dividend outlook in the months ahead.

In the next few months, America elects a President. Will they dump Trump, or vote for four more jaw-dropping years? Will President Trump be fully recovered before the election? Brexit will happen, one way, or another. The economy and the virus will be closely intertwined for a while longer yet. Uncertainties abound. But what we can be pretty sure of is that money will remain astonishingly cheap for some time to come. So far the economic lesson of the pandemic is that cheap money beats just about anything. With economies trying to bounce back, that cheap money is likely to have ever more powerful effects.

We will maintain our focus on cash generative businesses with strong competitive moats. We believe this is the best way to achieve superior returns in the long run, even if it means that sometimes we will be holding stocks that are out of favour. Our belief is that as long as the business itself is robust, market sentiment can puff and blow, but in the long run the superior financial performance of top quality business will win out.

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