HL Select UK Income Shares - Quarterly Review

Steve Clayton - Fund Manager

11 July 2019

The last three months saw the stock market return to a gentler pace of change after the sharp falls and recoveries of the previous periods. Overall, the UK stock market delivered a total return in the quarter of 3.3%, as measured by the FTSE All Share Index.

Economic growth looks to have weakened during the quarter, with the Construction sector especially impacted. Manufacturing activity slipped back, as stockpiling ahead of an expected Brexit in late March came to an end.

Uncertainties abound, with trade disputes between President Trump and pretty much everyone else sapping confidence abroad. Back home, Brexit and the broader political malaise have hardly helped to lift animal spirits. But despite this markets continued to make progress.

Predicting the future course of the stock market is rarely achieved with any accuracy and current conditions hardly help. We prefer to just focus on the individual companies that we invest in and look for signs of progress or setbacks in their longer term prospects.

If the companies’ revenues and profits perform as we expect, then we would expect the investments to prosper in the long run. Most of our investments are in companies with long track records of success. Indeed that is one of the most important factors we consider when making our selections for the funds. Please remember that past performance is not a guide to the future. All investments and their income will rise and fall in value so you could get back less than you invest.

Fund performance

The fund inched forward during the quarter, with a return of 3.1%*. Dividends continue to be paid each month and we were pleased to be able to raise the rate of dividend payable per unit held by 5% in April. We were also pleased to say we currently expect the final dividend for the year to rise by at least the same rate, although investors should remember that dividends and yields are variable and not guaranteed, or a reliable indicator of future income.

Past performance is not a guide to the future. Source: Lipper IM*, Correct as at 30/06/2019.

Annual performance

Past performance is not a guide to the future. Source: Lipper IM*, Correct as at 30/06/2019.

N/A† full year data unavailable as the fund launched in March 2017.

Strongest contributors

Past performance is not a guide to the future. Source: Bloomberg, Correct as at 30/06/2019.

BCA Marketplace has received a takeover bid from TDR Capital, a private equity group with other automotive interests. We’ll be sad to see them go; we thought they had great potential for long term cash generation, even if automotive markets generally are facing an uphill struggle currently.

Auctioning vehicles carries on, whatever the state of the new car market and auction lots are little more than a strip of tarmac, costing little to run. The stock is set to pay its final dividend in September, unless completion occurs beforehand. We will review the position at that point.

Sanne Group enjoyed a welcome return to form after quite a while in the doldrums. The stock had suffered from unexpected management change, as we reported last quarter, but it had also reported strong underlying growth. In a shift of sentiment the market has refocused upon Sanne’s growth potential which we believe to be strong.

The Alternative Asset markets that Sanne serves look set to continue to receive strong investment flows whilst interest rates remain at rock bottom levels. This is fertile ground for Sanne, and we expect demand for their fund administration services to be robust.

We hold the shares because once signed up to administer a fund, the arrangement tends to continue for the entire life of the fund. That makes Sanne’s revenues highly recurring, which coupled with underlying market expansion creates a potent growth cocktail.

Relx is one of those businesses where it’s easy to fall asleep whilst watching them grow. The markets they serve tend to be rather predictable and management show little sign of wishing to spring surprises onto shareholders. We like it a lot. The business is increasingly digital and almost entirely based around selling intellectual property, from academic research to risk analysis to customers who come back again and again.

GB Group profess to be pleased with their recent acquisition, IDology, mentioned in last quarter’s review, which is just as well. The existing business reported organic underlying growth of 11.5%. We see a huge runway for growth in front of GB Group. Demand for their identity and location verification services from the e-commerce sector is buoyant, and many of their services end up deeply embedded in their clients’ workflows giving them a strong recurring nature.

Paypoint would have delivered an even stronger performance, had they not received notice of a significant contract loss toward the end of the quarter, which knocked the shares back.

The business operates a network of terminals on the counters of convenience retail stores that allow people, often the unbanked, to pay bills for services ranging from utilities to rents, or collecting and dropping off parcels.

The business has been making steady progress, but the loss of the British Gas bill payment contract will hold growth to low levels this year and next. The business is hugely cash generative and remains so, supporting the group’s generous dividend policy. But please remember that income is variable and is not guaranteed.

Weakest contributors

Past performance is not a guide to the future. Source: Bloomberg, Correct as at 30/06/2019.

The tobacco sector had a dreadful quarter, following on from a strong Q1, to leave the sector 4.6% ahead for the year to date. Sentiment toward the industry is very volatile currently. The US health regulator is taking a more assertive stance toward traditional tobacco products and has also intervened to impose some control over newer, allegedly less harmful products, such as e-cigarettes.

In my opinion, we’ve rarely seen such a complete divergence between the companies’ own opinion of the outlook and the market’s rating of the industry. So far there is little sign of the industry’s cash generation being impacted.

XPS Pensions, the defined benefit pension’s administrator, released very disappointing full year numbers on 27 June. Both profitability and sales came in below expectations and cash conversion was much weaker than expected. This led to a c. 40% decline in the share price.

We are quite frankly dismayed by these results. XPS should be a highly predictable cash machine. The business should be thriving, given a number of recent favourable regulatory developments in the marketplace. The reason it isn’t can only be put down to poor management execution.

The Punter Southall (PS) acquisition has proved much more difficult and time consuming to integrate than management anticipated and this has distracted them from taking advantage of opportunities in the core business. It’s now clear the management team didn’t understand the PS business as well as they thought and the integration process has been poorly handled.

Greene King - We have now exited this position. Our view is that this is a business that is being steered carefully through some pretty rocky & stormy seas. Pub operators face challenges ranging from rising wage bills to increased regulatory and taxation costs. Greene King has done well to mitigate these, but nonetheless faces ongoing pressure on its margins.

For pubs to continue to draw the crowds in, the owners must invest in the fabric of the buildings. This is absorbing a lot of the business’s cash flow and preventing it from making meaningful reductions to its indebtedness. A new CEO has arrived, signalling no change in strategy.

We believe this will leave the business unable to bolster its financial reserves without a major upturn in trading, which we do not see coming any time soon. Overall, we made a loss of 1.4%, reducing the value of the fund by less than 0.1% on the position, including the value of dividends received.