HL Select UK Income Shares - Q3 2022 Review

James Jamieson - Fund Manager

27 October 2022

Market review

Markets continued to be buffeted by events in Ukraine, the cost-of-living crisis and tighter monetary policies around the world. The UK Equity market generated a total return of -3.45%* during the third quarter. Real Estate was especially hard hit as the rising cost of debt weighed on earnings, while asset values were threatened by increasing signs of recession. Telecommunications also felt the pain from increasing cost of capital, given significant debt levels in the sector. Information Technology and Energy were the stand outs at the positive end, although the former is somewhat misleading as 3 of the top 5 constituents are subject to takeover and significantly skew the performance upwards.

Inflation remains central to markets both structurally and cyclically. While its existence has been present for some time, investors were hopeful that Central Banks would refrain from continuing to raise interest rates in the name of supporting the fragile post-COVID recovery. Anecdotal evidence to the contrary, commentary from the Fed at the US Jackson Hole symposium and capitulation from the ECB all served as a ‘hawkish wakeup’ and dispelled ideas of a major pivot away from monetary tightening. Meanwhile the underlying forces that perpetuate pricing pressure rumble on, from the Ukrainian war, to supply chain disruptions and a tight employment market buoying demand.

The recent mini-budget proved anything but mini. The Conservative administration’s new fiscal policies were badly received by the investment community, nearly catalysing a financial crisis with global ramifications and stirring further political disarray at home. The Bank of England subsequently stepped in to manage the fallout and while they succeeded in containing extreme disorder, uncertainty remains high.

Fund Review

Total Return (%): Fund v Index v Peers

Past performance is not a guide to the future. *Source: Morningstar Direct to 30/09/22

The portfolio delivered a total return of -5.89%*, underperforming the market over the three months and marginally outperforming the peer group. Information Technology and Energy were the notable positive contributors, while Consumer Discretionary and Communication Services were the main detractors. During risk-off periods like the one which precipitated the market sell off in the latter half of the quarter, the fund should typically be slightly better supported than comparables given its quality bias, despite the inherent properties of an income mandate which work against it. On the subject of how your money is allocated, let’s explore what has been done through a period of elevated turnover and more importantly, the reasons for doing so.

The return of inflation and a shift in the monetary backdrop leads us to believe that we are now in a different regime, with the era of very cheap and easily available money now passed. These changes make for tighter liquidity conditions and a more difficult operating environment for companies. Which ultimately means that the valuations previously ascribed to long duration growth are no longer appropriate. As a result, risk exposures of every description need to be reconsidered, in order to reflect the change. To this end and after comprehensive appraisal, we have structurally optimised the portfolio, most notably increasing the fund’s liquidity profile.

When it became clear that Liz Truss was likely to be the next UK Prime Minister but in advance of the subsequent mini-budget that followed, we were concerned about her lack of regard for fiscal discipline. The technical extension being a weakening Pound and stronger US Dollar so from a top-down standpoint, we repositioned the fund away from domestic UK businesses to carry a more Global tilt, in order to mitigate the associated earnings risk that may follow due to the impact on demand and currency translation. This move also served to achieve the previously mentioned objective of increasing liquidity.

Coupled with our anticipation for the economy to enter recession and the potential for a credit cycle to follow, defensiveness in the portfolio was increased. This was expressed via our sector and stock level positioning. We also conducted balance sheet stress testing, using a higher hurdle in our scenario analysis to discern vulnerabilities to a rising cost of debt and the consequential threat to earnings and dividends. By the same accord, extra focus was placed upon operational resilience to ensure that the portfolio companies can weather tougher times ahead and capitalise on their relative strength to emerge stronger than peers when recovery comes about.

It is important to note that our underlying investment philosophy remains totally unchanged. We maintain that pursuing quality cash generative companies that will compound over the long term is the best way to create value for you, our clients. Next we look at the major contributors, good and bad to the fund’s performance in the quarter.

Stocks Review

Winners

Past performance is not a guide to the future. Source: Bloomberg (30/06/22 – 29/09/22)

Much like the last entry there was a standout performer this quarter, similarly driven by a takeover approach from US private equity. GB Group is a technology business that provides applications to verify the identity of people and their physical location. As you can imagine this has many uses in our internet age, with demand driven by both more digital users and ever more complex fraud. So it is no surprise that the attractive valuation and desirable intellectual property are in target for acquirers. At the time of writing the deal has just been terminated as the parties could not agree on price. Irrespective of a transaction materializing, we see significant unrealized upside.

Diageo and Experian both previously featured in the ‘Losers’ table, victims of highly rated stocks coming under pressure. Markets tend to over-extrapolate, so they enjoyed a certain degree of reversion in the third quarter. But the old adage ‘fundamentals eventually win out’ appears to ring true and it serves well to bare this in mind during periods of volatility. We are confident that these companies remain global leaders and as recent trading updates demonstrate, they have continued to deliver positive operating momentum. Regarding our expectation of a deteriorating economic outlook, Diageo sells staple products with low correlation to the cycle and while Experian carries a certain decree of sensitivity, our work suggests that the secular growth on offer more than offsets that.

Collectively, the Energy sector has performed well and there is little nuance at the company level, with Shell and BP both top five contributors to the fund. The forces which determine the economics of energy prices are complex, as are the new government redistribution mechanisms being announced to redress the dislocations and fallout that become of higher energy prices. We believe that energy producer margins look well supported and even when factoring-in higher taxation, the considerable future cashflow generation and cash returns to shareholders were not yet reflected in valuations. So we increased our exposure to the sector during the period.

Losers

Past performance is not a guide to the future. Bloomberg (30/06/22 – 29/09/22)

Extremes are recurrent throughout this post-mortem which is perhaps not surprising given the elevated volatility. In keeping with this, Sabre was the largest negative impactor after delivering a profit warning and dividend cut at the start of the quarter. The company is a niche motor insurer serving customers in the UK. In essence, claims inflation came through at a higher rate than the price increases they were passing, resulting in a hit to profits. Having delivered this update only weeks after assuring the issue was in hand, there is also a credibility question at play. The initial attraction was their superior underwriting record, but that is now called into question so the position is under review.

Litigation is a tail risk that is hard to anticipate and quantify. A case has been brought against GSK concerning a discontinued heartburn drug called Zantac, claiming that if left too hot or cold it can become carcinogenic. This is not a new story and the Federal Drug Agency in the US found no evidence of this a number of years ago, latterly corroborated by various other clinical studies. The company refutes the claim and encouragingly, the first trial was dismissed. Unfortunately definitive outcomes can take a long time to come through and cost of settlement can be considerable. Investors don’t like either of these things which explains the poor performance. This legacy set back is frustrating but with the shares now discounting a worst-case outcome and progress being made in the core business, we remain constructive and monitor it closely.

The moves in Tritax Big Box, Primary Health Properties and Persimmon are not predicated on new company information and have been explained in the Real Estate sector Market Review commentary. Despite our caution regarding the economic outlook (see more below), the derating that has taken place due to the macro stresses that may threaten the property market does not appear commensurate with where we project demand to settle for these three operators. With this in mind their robust income streams remain a desired component of the portfolio composition.

The Outlook

Finally turning to the outlook, inflation is set to stay front and centre given its bearing on: politics, policy, society, industry, consumption, growth, innovation and in consequence, asset pricing. The questions exercising us concern when it will moderate, the policy response to manage it and how an economic roll-over will temper it? Not to mention how China will affect the equation when fully reopened after an unrepresentative period of absence under their lasting and severe COVID measures.

On the subject of policy, the UK sits at a highly unusual juncture, with monetary and fiscal policy moving in opposing directions. Is the intent to stimulate demand or dampen it, and which will prevail? We believe that central banks unencumbered by governments will continue to raise interest rates even if recession does materialise, at least until they perceive inflation to be under control.

Until now earnings have remained surprisingly resilient thanks to full employment on the demand side and corporates pulling levers to help protect profitability on the supply side. The outlook commentaries from companies suggests that this is beginning to change and with our expectation for softening conditions going forward and a deterioration in sentiment, we anticipate downward revisions to earnings estimates which have remarkably remained in positive territory.

The changes we introduced to the portfolio in the third quarter are aimed at managing these risks. It is worth remembering that the stock market and the economy are not the same, even though they often march hand in hand. Great businesses can keep improving even when the economy and the stock market are faltering. This can create opportunities for long-term investors.

Furthermore the UK harbours a multitude of fantastic global franchises which aren’t contingent on local factors. So, in spite of how the domestic situation works through, we can still attain exposure to other seams of growth on offer around the world. As conditions get tougher, we are focusing ever more on seeking out these opportunities.