HL Select UK Shares vs. FTSE All Share

Charlie Huggins (CFA) - Fund Manager

29 December 2016

Steve and I are, quite frankly, data nerds when it comes to investing and in this blog, it shows. Sometimes though, the numbers tell as much of the story as the words. So if a statistical analysis of the valuation and growth characteristics of the fund appeals as much as a cold left-over sprout on Boxing Day, apologies. Just don’t say you weren’t warned...

Before launch, we laid out six characteristics we look for in companies on our investment strategy page, and now the fund is live we want to see how the companies we’ve invested in compared with that strategy as well as the market.

All of the data supporting this article has come from Bloomberg and when we talk about the wider market, we are using the FTSE All Share Index members for comparison. To give you the fairest view of the fund, we’ve had to exclude some of our holdings from the calculations as they’ve shown up as outliers. Please remember that past performance is not a guide to the future and ratios should not be looked at in isolation.

Superior Growth Potential

Source: Bloomberg. Correct as at 12/12/16

The average Price-Earnings ratio (PE) of the stocks chosen so far is 19.3x, which compares with the market average PE of 14.5x. So our chosen shares are a bit dearer than average on that measure. But we’ve been very focused on trying to find shares with great growth potential and we don’t mind paying a bit more for that.

The sales growth rates that have been achieved by the portfolio’s stocks works out at an average of 11.2%. The wider market has actually seen revenues falling, by some 2.8%, reflecting the sluggish global economy. So although we have paid a higher PE for our stocks, they have been delivering far more sales growth than the broader market.

Higher margins

Source: Bloomberg. Correct as at 12/12/16

We tend to view profit margins as a verdict, by customers, on the value they see in a company’s products or services. A high margin indicates that a business has something its customers really value and will probably come back for. At the moment, the average operating margin of the businesses held within the fund is five times higher than the wider market, which suggests our companies are offering something truly special.

Higher Return on Equity

Source: Bloomberg. Correct as at 12/12/16

Return on equity (ROE) measures how much profit a company generates with the money shareholders have invested. The fund’s holdings generate a return on equity far higher than the market, on average. Those sort of returns mean the companies the fund owns shares in should be better able to fund their own growth, without recourse to shareholders. Put another way, they should be more in charge of their own destiny.

More cash generative

Source: Bloomberg. Correct as at 12/12/16

Strong cash generation is really important to us because it keeps the bankers at bay, and gives companies the power to reinvest.

Despite trading on a higher PE than the market, the fund’s free cash flow yield is around a third higher than the market. This is telling you that the fund’s investments, after paying for day-to-day business needs, are converting much more of their profits into cash. The dividend yield is lower, but still healthy at 2.6%, and almost twice covered by free cash flow, leaving plenty left over to fund growth projects. Yields are variable and are not guaranteed.

Lower leverage

Source: Bloomberg. Correct as at 12/12/16

*EBITDA = Earnings before interest, tax, depreciation and amortization

While debt can boost returns, we are very conscious of the risks it brings. So we have taken a very cautious attitude to leverage in the fund.

The debt/EBITDA ratio compares the total debts of a company with the cash earnings it generates. The lower the ratio, the lower the leverage. The fund’s debt/EBITDA is well under half that of the market. In fact, some of the companies we have invested in to date have net cash on their balance sheet. The vast majority have debt/EBITDA ratios of less than 2.5x, and the small minority that don’t are forecast to deleverage rapidly over the next few years, given their prodigious cash generation.

Conclusion

With the portfolio almost fully built we can see that as a whole it has had faster growth, higher margins and returns, stronger cash flow and lower borrowings than the wider market. That’s exactly the outcome we were aiming for. Past performance is not a guide to the future.

With just under thirty holdings, the portfolio is concentrated and is likely to perform rather differently to the wider market as a (wholly deliberate) result. This means each company we’ve invested and have conviction in can make a real difference to performance but it is a higher risk approach.

We’re really under-exposed to commodities and highly cyclical companies. When they are doing well, HL Select UK Shares may well lag behind somewhat. But we’re playing a tortoise and hare game here. We think the underlying quality and growth potential of the names we’ve invested in will work strongly in the fund’s favour in the long run. Please remember the value of an investment and any income from it can rise as well as fall, you may get back less than you put in.

More about HL Select UK Shares Fund

View the key investor information document.

Read more blog articles