HL Select UK Income Shares – Q4 2021 Review

Steve Clayton - Fund Manager

28 January 2022

Market review

The final three months of the year saw the market push higher. A total return of 4.2% during the quarter built on earlier gains to create a full-year return from the FTSE All-Share Index of 18.3%. The market's strength came even as evidence mounted that inflation was proving to be more deeply established worldwide, not least in the UK.

Markets were encouraged by the evidence that although highly contagious, the increasingly dominant Omicron variant appears less likely to lead to serious illness.

The market's rise was somewhat erratic. The Beverages sector rallied strongly, up some 11.3% in the quarter as investors anticipated a wider reopening of the hospitality industry. Yet the Travel and Leisure sector delivered a negative return of 13.6%. Amongst the market's larger sectors, Banks were the best performer, delivering a return of 7.4%, whilst Oils were the weakest of the significant sectors, losing 1.4%.

The pandemic has created a series of challenges for businesses globally. Where production was shut down, shortages of goods have appeared. The interruption of logistics has left supply chains struggling to source all the required inputs. Price increases have rocketed, with factory input prices up 14.3% last month, putting manufacturers under pressure to push for increases themselves or face a squeeze on their profit margins.

The Bank of England has so far made only a token increase to interest rates, wary of stamping out the economic recovery underway. Most commentators expect limited further tightening, but we see this as finely balanced. Asset prices are buoyant, wages are rising rapidly, and the Consumer Price Index is already over 5%. Some counterbalances will help ease inflation in 2022, not least the dropping out of significant increases in 2021 from the year-on-year comparatives as the year progresses.

HL Select UK Income shares performance review

The fund added 2.0% during the quarter, a little behind the wider market performance. Indeed 2021 has proved relatively challenging for the fund, which delivered a full-year return of 15.6%, somewhat behind the index, as shown in the table below. Past performance isn’t a guide to the future.

The fund's style is to invest in high-quality businesses with robust finances and where we judge the competitive position to be so strong that the business has good prospects for delivering long term compound growth. Our belief in the ongoing digitisation of more and more economic activity draws us towards technology companies and other digital businesses. When these fall out of favour, we expect to lag but recover these periods over time through the longer-term growth they generate.

Our desire to generate regular and significant income from the portfolio also requires us to hold some relatively mature companies which pay relatively high yields.

In common with our sister fund, the HL Select UK Growth Shares fund, the biggest drags on performance in the quarter came from our holdings in technology and financials companies, whilst our most substantial contributions came from industrials and consumer staples holdings. We also saw valuable contributions from our Real Estate and Utility holdings. Below we discuss the drivers behind the stocks which had the most significant impact, good and bad, upon the fund during the quarter.

Significant winners and losers

Winners

Past performance is not a guide to the future. Source: Bloomberg to 31/12/2021

Tritax Big Box has been held since the fund launched back in 2017 and has been remarkably consistent. Management has been strong in its execution throughout. With the potential for value creation within their portfolio of development sites becoming more evident, the stock has been well supported. The pandemic has only accelerated e-commerce, creating further demand for the distribution assets that Tritax owns and develops.

Relx benefited from the market spotting glimpses of light at the end of the pandemic tunnel. It had seen its events business hit hard as many face-to-face exhibitions and conferences were cancelled and postponed. The prospect of these events being staged once again is a positive. More importantly, the group upgraded their growth expectations when they reported on Q3 trading back in October. Relx now sees growth trending above historical norms, with double-digit revenue gains in their Risk division the most significant driver.

Diageo set out their growth plans in a Capital Markets event in November, which was well-received, enabling the stock to progress to new all-time highs in the weeks afterwards. The group launched a new £4.5bn capital return programme and highlighted twenty consecutive years of dividend growth, despite the pandemic. One of Diageo's enduring attractions to us is the strength of its cash conversion. Even during the 2020 financial year, when much of Diageo's licenced trade customers were forced to close, the group generated over £1.5bn of free cash flow.

National Grid had a stand-out quarter, rallying to an adjusted close all-time high towards year-end. During its recent Capital Markets Event, Grid pointed out that the energy transition was creating multi-decade growth opportunities. The company also raised its guidance for earnings this year after a strong performance from its interconnectors between the UK and other nations' power grids.

Losers

Past performance is not a guide to the future. Source: Bloomberg to 31/12/2021

GB Group announced a substantial acquisition and a placing of stock to part-fund the deal. They paid $736m for Acuant Inc, a US digital identity verification specialist. The price paid was full, but Acuant should accelerate the enlarged group's growth rate and enhance its operating margins. Whilst institutions, ourselves included, supported the deal, the shares have struggled since, despite the group also announcing encouraging trading.

We feel GB Group has a good long term growth franchise and has shown skill historically in using M&A to accelerate their growth trajectory. Still, there are periods when the market will greet deal-makers enthusiastically and times when it will not. With technology stocks generally struggling in the broader market toward year-end, this deal was unfortunately timed. Messaging on underlying trading was positive during the quarter, and we remain strong supporters of GB Group for their long-term potential.

Sabre Insurance was held back by a pandemic-linked drop in revenue. Sabre provide motor insurance for non-standard risks. The pandemic hit premiums across the sector, which are proving slow to recover. Significant regulatory changes are now impacting the industry, which should benefit the group. Sabre has always priced for profit, not volume. Other insurers have tended to win customers through an unusually low quote, then raised the policy price at each renewal. The FCA now requires insurers to provide the same quotations to old customers as they would new ones. This should offer upside because Sabre's quotes should prove to be competitive in more instances if rivals are no longer subsidising new customers through the door. Either way, the group continues to generate cash and is paying attractive levels of dividends.

Close Brothers reported solid enough progress in their November trading update, but there was not enough to send analysts scurrying off to upgrade their forecasts. The lending book is growing by 2.4% in the group's Q1 to end November, but it does not look to us as if Close will add the same degree of market share that it has in previous recoveries. Following the financial crisis, new regulations obliged regular banks to strengthen their finances. So Close Bros' competitors appear better placed to maintain lending than in previous upturns. However, the group remains well capable of growth and is strongly capitalised, supporting future dividend payments to investors.

New holdings

We made a few changes to the portfolio during the quarter, aiming to increase the underlying growth rate in the portfolio without impacting the income generated.

Rio Tinto, one of the world's leading minerals producers, comes into the fund. Their key asset is ownership of a vast iron ore mining complex in Western Australia. The ore they mine has high iron content and is easily accessed. This, combined with dedicated transport facilities across the desert to coastal ports, gives them an exceptionally cost-effective business. Only a handful of companies globally have assets that have similarly low production costs. Collectively they do not produce enough to supply global demand. That means that the market price is set by higher-cost producers, leaving a comfortable margin between selling prices and RioTinto's cost of production. With a significant expansion project completed in recent years, Rio is now significantly cash generative and able to return substantial sums to shareholders through a combination of ordinary and special dividends.

Experian is another new holding. They run one of the world's largest credit bureaus and provide commercial clients with services ranging from credit ratings to information and analytics that enable banks, retailers and others to make decisions about who to lend to or how best to target marketing. The business is already highly digital and getting more so. With the core credit data division receiving input data from banks for free, the company has a built-in tendency to throw off cash. In an increasingly data-centric world, Experian is strategically well placed. The business has generated strong growth historically and should continue to do so. Dividends have almost tripled since before the financial crisis, and we expect continued growth in the payout in years to come.

We have taken a position in Schroders, a well-known asset management business. The group has a history of solid governance and robust performance. The founding family retain a substantial interest in the company. We have chosen to hold the non-voting shares, which traded at a significant discount to the ordinary shares. Both classes receive the same dividend per share, so we have increased the yield earned, whilst having exposure to the same business. The family interest ensures, we believe, that the company will continue to be well-governed and that the extra yield is ample reward for the technical risk of not having voting rights.

We have also shifted a significant proportion of our holding in Imperial Brands into its peer, British American Tobacco (BATS). Both are exposed to the same industry trends. Still, BATS looks to be better placed in transitioning its portfolio away from traditional tobacco products to the newer generations of Potentially Reduced-Risk Products, such as vaping and heat-not-burn. The overall impact of the switch was to lower the amount of exposure to the sector.

Monies to fund purchases were raised by top-slicing the Tritax Big Box position, which had performed very strongly, to become the largest single position in the fund. We remain significantly invested in Tritax and expect to remain so. We also sold the last of our position in Sanne.

Outlook

2022 is likely to be a year when overall market performance in most major nations will be determined by the actual and expected levels of inflation and interest rates. If inflation returns to lower levels, without central banks needing to snatch the punch bowl away too emphatically, then there is much to be hopeful about. Ongoing low-interest rates in this scenario will support investment into equities generally, whilst the moderate rates of GDP growth implied by modest inflation ought to augur well for the performance of quality growth shares.

Should inflation prove stubborn and central banks become obliged to raise interest rates more significantly, then markets may struggle. Higher interest rates would increase the discount rates that investors use to value stocks. This could have a disproportionate impact upon highly rated shares, especially if they fail to meet the market's expectations for profitability or growth.

We will write a blog going deeper into our view of the outlook for markets shortly.

Our strategy focuses on companies with exposure to the fast-growing digital economy and which possess pricing power. If you can set your own prices, your product must be sought after: time then becomes your friend. Markets may well gyrate whilst it becomes clear what the actual direction of travel will be. But businesses with pricing power can grow their real earnings, whatever the level of inflation.

Past performance is not a guide to the future. Source: Lipper IM to 31/12/2021

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