HL Select UK Income Shares - Q4 2022 Review

James Jamieson - Fund Manager

23 January 2023

Market review

Markets ended the year in a better mood than they began it, with the FTSE All Share index delivering a return of almost 9% in the final quarter. After the shocks of the brief Truss administration, a period of more restrained policymaking was welcomed by the markets. The Bank of England supported pension funds by providing liquidity and the excessive premia seen in the government bond markets subsided.

Interest rates continued to rise, with two further increases in the quarter. At the time of writing rates sit at 3.5% but with inflation far above the target level, further rises seem likely. Much talk has been made of the squeeze upon household spending power from higher interest rates and rocketing utility bills, with their impacts exaggerated by below-inflation wages growth. So far though the economy looks to be limping along.

The most recent GDP data showed a -0.3% decline in the three months to November, which sets the stage for a lackluster pace of growth in the quarters to come. The depth of the UK’s recession in 2023 is still up for debate. Strikes in the public sector, and some of the privatised industries, will be acting as an additional brake and whilst utility costs look set for further hikes, the proportionate increase is unlikely to be as great as that seen in 2022.

Amongst the major sectors of the market, Pharmaceuticals, Banks and Miners rose more than the wider market. Telecoms has performed so badly for so long that these days, it isn’t really a major sector. Having already shrunk to the point where it accounted for less than 2% of the market’s value at the beginning of the quarter, it still managed to be the worst performing sector over the period, losing another 11% in value. Oil and Gas stocks lagged the market slightly, in sharp contrast to the wider global market where they were the leading sector of all. Perhaps UK investors decided to punish the “Sin Sectors” in the quarter, for both Alcohol and Tobacco producers were also notably weaker than the wider market.

Fund review

The portfolio delivered a total return of 5.5%*, lagging the market over the three months. The underperformance can roughly be attributed equally between one stock (GB Group) and the Value style leading the market. HL Select is focused on Quality and Growth rather than the Value style of investing. In other words we mainly invest in businesses with attractive prospects, stretching a long way into the future, with strong competitive defenses. We seek to avoid businesses that might appear optically cheap, but where prospects are unattractive beyond the very short term. Of late though, Value has been in vogue. While we try to limit this impact as explained in the last blog, we remain true to our philosophy and have no intention of changing our spots to stripes.

In terms of sectors, Financials made the biggest positive contribution to the fund’s value. In particular Legal & General and Close Brothers shone for us (see Stocks Review). Healthcare was the other leader, with very strong performance from AstraZeneca which is mentioned below. At the other end of the spectrum, Information Technology did not fare well over the period given its low exposure to the Value style. In addition to the sector performing badly overall, GB Group had an especially tough quarter as explained below. Communication Services was also weak, underperforming other areas of the market.

Total Return (%): Fund v Index v Peers

Past performance is not a guide to the future. *Source: Morningstar Direct to 31/12/22

Stocks review

Winners

AstraZeneca is always announcing news flow. But we think sentiment played the larger part in the stock’s strong performance in the quarter, given the relatively minor nature of company announcements in the period. We see AstraZeneca as offering the best growth profile in the sector, so perhaps the market is beginning to agree?

Next also put out an encouraging trading statement. Impressive given there aren’t many UK-centric retailers that we know that are delivering improving operating results in the face of the current challenges. Exceptional dexterity and vision from management have seen them adapt to the changing high street by shifting business online, rationalizing the store footprint and better utilizing the physical shops by becoming fulfillment centres for other smaller retailers. We believe this won’t only ensure their survival, but their size and relatively stronger position enables them to capitalise on the changes by taking share and striking deals on favorable terms. The acquisition of Joules during the quarter is a great example of this.

Close Brothers saw little in the way of company specific changes. But as alluded to above, financials enjoyed a strong fourth quarter in general and Close was no exception. Beyond improving profitability thanks to higher interest rates, November produced some encouraging developments for banks. The first of these is the reduction in bank surcharge taxes from 8% to 3% was confirmed which will boost earnings. The second is that the government is reviewing the rigidity of regulations concerning how banks have to ringfence different pools of capital.

Rio Tinto is an unusual position for us, for it is generally regarded as falling into the Value camp. However, Rio possesses some of the lowest cost iron ore reserves to be found. This offers tremendous cash flow potential so we are happy to hold it. These cash flows give it the ability to fund its own growth for years to come, whilst helping to prevent our Growth style from becoming too unbalanced. The Chinese authorities U-turned on their conservative COVID policy which caused investor excitement on expectation of better demand for metals. This is undoubtedly good news for Rio in the near term, but the fragile state of global economies could still cause problems later on and we will manage our exposure to Rio Tinto accordingly over time.

Legal & General had a busy quarter, courtesy of Kwasi Kwarteng. The surge in yields following the mini-Budget wreaked havoc for some of L&G’s pension fund clients. Many of these funds use a technique called Liability Driven Investment (LDI). This is designed to help funds close their deficits by better matching assets and liabilities. Like most clever schemes devised by City folk it involved leverage. Whenever borrowings meet unexpectedly large falls in asset values, pain follows. Chancellor Kwarteng delivered the tumbling asset values. The market feared that L&G would be exposed and the shares tumbled. After the company assured the market that it was the funds themselves that carried the liabilities and that Legal & General’s broader business was on track, the shares recovered.

Past performance is not a guide to the future. Source: Bloomberg (30/09/22 – 29/12/22)

Losers

GB Group has been the frustrating victim of timing. In Q3 it was the top contributor in the fund after receiving a takeover approach from private equity. Capital market conditions changed during the negotiation period, and the surging cost of debt led to the bidder failing to make an offer sufficient to win GB over. Higher borrowing costs have challenged the economics of leveraged private equity transactions more broadly. Anecdotally this has resulted in a record decline in Mergers & Acquisitions (M&A) in recent months. The takeover failed to materialize at a time when Information Technology, Mid Cap and Growth stocks were very out of favor.

The company put out a decent enough trading update in November. As you might imagine we have been doing extra work to stress test our assumptions and engaged with the company to re-appraise the situation. We found no cause to revise our expectations at this time and now see even more upside to the investment than we had done prior to the bid talks.

The following laggards all shared the same principal driver of underperformance, which is their Growth, rather than Value, credentials. So to avoid repetition like a broken record, let’s focus instead on the other salient developments over the three months.

Diageo released a solid trading update in October, confirming a good start to their fiscal year in all regions. We are especially interested in companies that have the potential to come through tough times in even better shape thanks to their superior position and attributes to begin with. Like Next, Diageo is another good example of the strong getting stronger. The group’s strength allowed it to continue acquiring smaller rivals throughout the period, despite the wider M&A slow-down. To us, this only confirms that Diageo enjoys the privileged position, shared by few others, of controlling their own destiny.

Sage is a new holding in the fund and we were tactically using the share price weakness in the period to establish the position, using the proceeds from Emis who were acquired. The weakness is a result of the trends in the market and not born out of operational developments. Quite the opposite, with the company beating estimates and raising guidance when reporting their full year numbers in November. This is a good example of a quality business offering attractive growth that has derated and thus presents a good entry point for long-term investors like ourselves.

Ascential disappointingly features again. There is nothing out from them since we last wrote on it and as alluded to earlier, the negative current against smaller companies has continued.

Primary Health Properties features here for the second consecutive quarter, all be it with much less of an impact. The Real Estate sector performed poorly because the segment is taken to be a proxy on the UK economic outlook. However we believe that the company has credentials that insulate it from the impending pressures: very sticky occupants (medical practices), gilt edge rental receipts (ultimately it’s the government paying) and a conservative balance sheet with fixed rate, long-term borrowings. Founder Harry Hyman has announced his retirement in 2024. We think PHP has plenty of management strength on the bench and expect a smooth succession.

Past performance is not a guide to the future. Source: Bloomberg (30/09/22 – 29/12/22)

The outlook

The new year has begun smoothly enough, with the FTSE All Share index a few percent higher. But the economic course ahead is far from clear, making forecasting where the market is headed unusually fraught. Interest rates are very likely going higher, but by how much? Monetary policy works with famously “long and variable lags”. It would not be daft to interpret that as economists saying “we don’t really know what impact a change in interest rates will have, nor when it will be obvious that it has had any”.

All that we can do as fund managers is to focus on how we find businesses trading and listen to what their managers are saying about their customers’ behaviours. We will learn a lot more about that when companies release results, beginning toward the end of the month and into February. So far we would say that most managers are taking the trouble to sound cautious, whilst generally reporting pretty solid numbers. But change is clearly afoot. Conflict in Ukraine continues with little sign of any resolution. The UK housing market has clearly slowed down. Meanwhile on the other side of the world, China is adopting a more growth friendly position and reopening after very stringent COVID lockdowns.

Einstein was fabled to have said that compounding is the eighth wonder of the world and those that understand it earn it, while those that don’t pay it. This is the genesis of HL Select and we remain resolutely focused on finding these compounders. We believe this is the best approach to long-term investing and navigating periods of low visibility. To this end, Cranswick plc and Sage plc were added to the portfolio during the quarter. The rationales can be found on the website.

We have been reviewing dividend prospects for the remainder of the year and have come to the decision that the uncertain economic outlook merits a reduction to the level of regular monthly dividend. So we are reducing the payment by 0.05p, to 0.25p, to be reflected from the distribution made in late January. As always, the final dividend for the year paid in October will be a “mop-up” payment, consisting of all the distributable income received but not already paid out in the current financial year. Our expectation is that this payment will likely be meaningfully higher than the regular dividend rate. We confidently expect that your fund will continue to offer a yield that is at or above the market yield, although we must stress as ever that dividends are variable and not guaranteed.