HL Select UK Income Shares – The first three years

Steve Clayton - Fund Manager

5 March 2020

The HL Select UK Income Shares fund is three years old. Launched in March 2017 the fund has seen two general elections, three Chancellors of the Exchequer, one Brexit, albeit so far in name only, and one virus.

Right now it is the coronavirus that is grabbing the spotlight. Stock prices have tumbled worldwide and uncertainty abounds. Aside from the human cost of the disease, it is taking a toll on businesses through disrupting production, demand and availability of goods, weakening cash flows and raising the risks of doing business around the world.

As of 3 March, the coronavirus has caused a little over 3,100 deaths. Academic writers have estimated the annual death toll from the flu at anything from 99,000 to 650,000 each year. Perhaps we are all too concerned about coronavirus and insufficiently worried about influenza.

The story so far

When we launched the fund we wanted to create a fund that could deliver an attractive total return, including a regular income, capable of growing over time. So far the fund has declared and paid a dividend for every month since launch. We pay eleven regular dividends each year, plus a final payment that mops up all of the income that has not already been paid out to investors. The fund’s financial year end is 30 September, so the final dividends are paid in late October each year.

Accumulation unit holders will see these dividends rolled up into the value of their units, and holders of the fund’s Income units have the dividends paid into their HL accounts. The regular dividends were set at 0.30p per income unit at launch and so far we’ve been able to raise the level of regular dividends twice, so that income unit holders now receive 0.325p per unit per month, a total increase of 8.3%. Please remember though that dividends are not guaranteed. Last year the fund paid a final dividend of 0.657p, making a total for the financial year to 30 September 2019 of 4.03p. Past performance is not a guide to the future.

The three year total return of the fund is 0.5%* to 2 March 2020. Effectively all of the fund’s earlier gains have been wiped out by the market weakness induced by the coronavirus outbreak.

When we launched the fund, we also promised to keep our investors in touch with their money. If you visit the HL Select webpages you can find breakdowns of the fund’s holdings and our rationales for each position.

We’ve also kept our investors in touch through our blogs, which can be read on the website and are emailed directly to investors.

Past performance is not a guide to the future. *Source: Lipper IM to 2 March 2020. As the fund launched on 2 March 2017, performance data prior to this date is not available.

Lessons learned in the first three years.

We’ve had some notable hits and misses so far. Our worst performer came in the shape of Provident Financial. We bought into the specialist lender at fund launch, encouraged by a decades-long track record of robust profitability. But the company bungled a re-organisation, leaving the business in disarray and then went on to reveal regulatory difficulties. We decided to take our losses and sell out. So far that looks to have been the right decision for the shares are well below where we exited. The lesson here was to be more wary of businesses introducing operational risks. Provident Financial should have run a regional test trial to prove their new structure would run to plan. Instead they opted for a Big Bang approach, which cost their investors dearly.

When it comes to money, dull is not necessarily boring, but nor is excitement the same as fun. We invested into XPS Pensions, a business that provides actuarial and administrative services to traditional pension schemes. They acquired a rival business then struggled to put the two operations together. Cash generation was impacted, undermining our rationale for holding the business. This was another example of a business raising its levels of operational risk, in this case through deal-making. We eventually sold out the position having taken a significant loss on XPS.

Software companies have proven to be some of our most successful investments. Fidessa was a holding from the off, and eventually attracted a series of suitors keen to get control of their market-leading software systems that connect investment businesses and cut the cost of trading. Fidessa’s business model is highly cash generative, because fees for using their platform come with very limited incremental costs to Fidessa, allowing much of the revenue to flow through to profit. By positioning itself at the heart of an enormous global industry, Fidessa had made itself irresistible and the stock was one of the fund’s most successful investments to date.

Another software success has been GB Group, which provides ID checks, location verification and fraud prevention software to businesses globally. Rising levels of e-commerce and financial regulation are pushing demand higher and GB has grown like Topsy. We’ve taken some profits from this position, but retain a significant position and look forward to watching the business continue to grow. Like Fidessa, GB’s products sit at the heart of major markets that often have demanding regulatory requirements. Though as ever, there are no guarantees.

Focusing on cash is critical. Where positions have not generated the results we hoped for, all too often it was because the business failed to generate the expected levels of cash flows. Where companies have surprised on the upside with their cash flows, they have tended to perform well. Our positions in internet companies Rightmove and Auto Trader have both generated good profits, and both have been consistently strong cash generators.

Companies that saw cash flows weaken, like WPP or Domino’s Pizza have seen their share prices struggle. WPP was the wrong side of an industry shift, whilst Domino’s made some ill-advised overseas forays and squandered their financial strength on buying back shares for little tangible benefit.

Looking forward

These are uncertain times. Coronavirus will do what it will. We’re focused on the sort of businesses where we expect the impact to be muted. Primary Health Properties will see its rents paid by the NHS regardless and Pennon’s customers will carry on paying their water bills. People will not stop going to their corner store to put money on the gas meter, so Paypoint should carry on without too much interruption to trade. Indeed it may even benefit if more people use the Collect+ parcel service rather than heading off to town to shop.

But most businesses will feel some impact if people change their behaviours, whether they are poorly or well. We’ve always tried to avoid businesses with uncertain revenues and risky debt levels. That ought to serve the fund well in the current environment.

Will markets bounce back, or continue to be blown by the wind? In the short term, so much is changing rapidly that any projections are for entertainment purposes only. But we do know that central banks are likely to ease monetary policy in the face of economic weakness and that governments are more open to fiscal stimulus than for many years. Interest rates look set to stay at low levels for some time to come. If that is true then equity dividends are likely to be highly sought after, which should ultimately prove supportive for share prices.

We will carry on paying dividends each month. At the moment, our projections suggest that the fund should be comfortably able to support the regular monthly payment of 0.325p per Income unit. The outlook for the final dividend is promising. But as we always say, dividends are variable and not guaranteed. At a time when the world is reacting to an event like coronavirus it is important to remember this.

We know how much our investors value receiving regular income and we consider this whenever we are making decisions about exiting or creating positions. In the long run, the total return is what matters most, so our role as managers is to create a portfolio that generates income without impeding the portfolio’s ability to generate capital gains over the long term.

We’d like to thank all of our investors for their support over the first three years and we look forward to telling you about the portfolio’s progress in the years ahead.