HL Select UK Income Shares Quarterly Review

Steve Clayton - Fund Manager

22 October 2019

The stock market drifted sideways through July before a brief dip in August, followed by a rally in September to leave the FTSE All Share Index fractionally lower at the end of the period. Dividends paid out during the quarter meant that overall, there was a total return for the All Share index of 1.3% for the period.

Investors had plenty of distractions to cope with; trade wars ebbed and flowed, Brexit led British politics into the courts and a new Prime Minister lost his majority in Parliament on purpose and clocked up more Parliamentary defeats in his first few weeks in office than most predecessors managed in their lifetimes. In the background, economic indicators deteriorated at home and abroad and the level of interest rates was cut in both the USA and the Eurozone.

At the time of writing, the Brexit outcome is still very much up in the air. The end result may well be significant for the direction of sterling, if the currency’s reaction to the referendum result is any guide. When sterling moves, the value of companies’ overseas earnings moves with it, but in the opposite direction.

The next few months have the potential to be volatile as a result, and it’s quite possible the UK market could perform very differently to other global equity markets in the near term. In the long run Brexit will simply be one of the many challenges that businesses have to navigate around. Of more concern to many boardrooms will be whether the culmination of the Brexit process will lead to a change of government in the UK. 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.

Income boost

We aim to pay a regular income to investors, rising over time, although of course, dividends from the fund will be variable and cannot be guaranteed. So far we have paid out a dividend in every month of the fund’s existence.

The fund’s financial year end is at 30 September each year. We pay eleven monthly dividends and one final dividend, which you should receive this month if you hold income units.

The difference is that the regular monthly payments are designed to be quite consistent, based on the expected level of income for the year and taking into account any special factors that we are aware of. For the final dividend, we pay out all of the remaining income that has been received that financial year and not already distributed.

This year we paid six regular dividends of 0.3p per income unit (accumulation holders see the income rolled up into their unit value instead). At the half way mark, we decided to raise the regular payment rate by 5%, and paid out 0.315p per income unit per month for the following five months.

The final dividend is set at 0.657p per income unit, an increase of 11.5% compared to last year. We would caution against paying too much attention to the rate of change in the final dividend, for it can be influenced by the arrival of one-off payments into the fund.

Looking to the new financial year, we run projections using Bloomberg data to track the expected level of income for the fund. Right now, these are suggesting a strong outcome, rather at odds with the current state of the stock market. Time will tell. In the meantime we are raising the regular dividend rate by 3.2% to 0.325p per income unit per month, which you’ll receive from November onwards.

Fund Performance

The fund was held back in the quarter by the impact of the short selling attack on Burford Capital and a profit warning from Sanne Group. Overall the fund lost 0.7%* during the quarter.

Past performance is not a guide to the future. Source: *Lipper IM, correct as at 30/09/2019.

Annual Performance

Past performance is not a guide to the future. Source: Lipper IM, correct as at 30/09/2019.

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 30/09/2019.

Sabre delivers sharp results

Sabre Insurance benefited from well received interim results during the quarter. Sabre specialise in insuring non-standard motor policies in the UK. They price for profit, not volume and are happy to stand back and write less business when market conditions are unfavourable.

Recent market conditions haven’t been great, so Sabre has allowed volumes to drift lower, but continues to earn high returns on the business it does write.

Premiums are expected to rise, as the rest of the industry adjusts pricing to reflect claims inflation. This has been driven by recent changes to the Ogden Rate, which determines how much insurers have to set aside to fund the long term care of accident victims. Also, modern cars are covered in sensors and safety features. When these help to stop accidents, insurers heave a sigh of relief. But when they don’t, the cost of repairing the vehicle can be far higher than just beating out a panel or two.

As the industry prices these costs into their rates, Sabre will be more competitive and volumes should recover. In the meantime the company’s significant capital surplus allows it to keep paying attractive dividends to investors.

Pennon gets political bounce

Pennon Group had a decent quarter. In part this was in response to the latest regulatory proposals, which look manageable to us, but probably the greater impetus came from the political arena. The Labour Party’s policies toward the utility sectors are highly contentious. With support for the Brexit party withering, and voting intentions seemingly swinging towards the Conservative Party, (according to pollsters YouGov), utility companies look less exposed.

Pharmas flourish

Our pharmaceutical holdings, AstraZeneca and GlaxoSmithKline both performed well in the period. Growing optimism around AstraZeneca’s drug pipeline has been backed up by a number of favourable pipeline developments, boding well for future profits, cash flows and dividends.

For GSK, there are signs that steps taken by CEO Emma Walmsley to reinvigorate the drug pipeline are beginning to bear fruit. First half results in July were slightly better than expected leading to increased earnings guidance. Importantly, GSK reiterated its intention to pay an unchanged full year dividend.

Just Eat, just sold

We sold out of Just Eat in the quarter, after it announced an agreed, all share merger with Takeaway.com - a European rival. In truth, there is little overlap between the two, despite both operating in the online food delivery sector. So we can’t see huge synergies to be won.

Just Eat had a management vacuum, having parted ways with their former CEO and an activist investor agitating for change. So we could understand why the board might have embraced a deal.

Competition in online food delivery remains intense though, with Deliveroo and Uber Eats snapping hard on established players’ heels. So we took advantage of the boost to Just Eat’s share price and exited the position.

Weakest Contributors

Past performance is not a guide to the future. Source: Bloomberg, correct as at 30/09/2019.

Burford still in muddy waters

Burford Capital fell sharply following a short selling attack. We’ve written at length on this already, explaining our decision to exit and the impact of the position on the fund over the entire period that it held the stock. During the quarter the position impacted performance by 1.6%.

Claims and counter claims by Burford and Muddy Waters continue and resolving the truth of the situation will be a protracted business, given the nature of litigation financing and the periods that cases can spend proceeding through courts.

Disappointing Sanne

Sanne Group had a terrible quarter, for which management have to accept responsibility. Having given an upbeat message to the City at their inaugural capital markets event in the spring, the company shocked investors with a profit warning just a few weeks later. A variety of reasons were given, none necessarily recurring.

Sanne took on new staff to run newly won business, then the client delayed the project, leaving people twiddling thumbs on full pay. The Private Clients business went backwards and is now under review. All in all, margins will take a hit in the first half of their financial year, even if overall top line growth remains in double digits.

We’re sticking with Sanne for now because the markets they serve still look very attractive, but execution needs to become more reliable for the company to fulfil its undoubted potential.

Oil price affects BP and Shell

Weakness in the oil majors, BP and Royal Dutch Shell, was caused mainly by on-going oil price volatility amid growing economic jitters. Shell also released disappointing second quarter results which saw profits fall by a quarter, although there were quite a few one-offs that impacted the results, which we do not expect to repeat.

Cash generation is what we most focus on, for it is cash that funds dividends and loan repayments. The outlook here remains strong and unchanged, underpinning an attractive 6.6% yield; although remember yields are variable and are not a reliable indicator of future income.

Legal & General solid

In our eyes, Legal & General did nothing wrong, but that did not stop the shares slipping during the quarter. Business levels look solid enough, and the group continues to write substantial business for pension funds looking to de-risk. The interim results revealed a 7.2% dividend increase, backed up by a 13% hike in profits and a 29% jump in cash released from operations.