How will Brexit affect the HL Select funds?

Charlie Huggins (CFA) - Fund Manager

25 January 2019

There are so many question marks right now around the UK’s political situation. Will it be a hard or a soft Brexit? Will the UK even leave the EU? What will happen to sterling? How will the economy be affected?

We don’t know the answers to any of these questions and in truth, we don’t spend much time thinking about it.

We have never made an investment decision based on political or economic factors. These things matter, sometimes, but they aren’t forecastable. Our job is to focus on things we can control - finding good companies to invest in – while seeking to limit the impact from those things we can’t.

The Great (British) Misconception

There’s a lot of negativity about the UK stock market given the uncertain political backdrop we’re in. But, to my mind, this negativity is misplaced. What matters is where a company generates its sales, not where it’s listed. And the reality is, most of the UK’s biggest businesses earn their money overseas. On that basis, the UK’s economic future becomes far less relevant to the stock market.

We invest in businesses of all sizes, with all but one listed in the UK. Yet the same is true for our stocks.

For the HL Select UK Growth Shares fund, we estimate that around three quarters of the sales come from overseas. For our HL Select UK Income Shares fund, the split is about 50:50 between UK and overseas sales.

Where are the sales generated?

Source: HL. Correct as at 18/1/2019.

Note, this is an approximation. We cannot be exact because companies do not always disclose sales by country, but we think these charts give a very good approximation from our analysis.

Digging deeper into our UK holdings

Let’s look more deeply at the domestic holdings we own – those whose fortunes are (in theory at least) more heavily tied to the UK’s economic prospects. The domestic names that are common to both the Select Growth and Income funds are shown in the table below:

Source: Bloomberg. Correct as at 18/1/2019.

We look to own businesses in charge of their own destiny. While no company can be completely immune when trouble strikes, some tend to be much more resilient than others. We particularly like companies that could continue to benefit from long-term trends, like the growth of e-commerce, which should persist whether the UK stays in or leaves the EU.

Once we find these businesses, we aim to hold them for the long term.

BCA Marketplace, a big position in both funds, is a good example of what we mean by a business in charge of its own destiny. 2018 was a bad year for the automotive sector. New and used car sales in the UK both fell, and new emissions regulations led to a raft of profit warnings from auto manufacturers and suppliers.

Despite this, BCA’s half year results in November showed earnings and the dividend growing by over 15%. This is explained by its dominant and well-diversified business model, combined with growth in the proportion of cars being sent to auction.

Both Domino’s and Just Eat are catering to hungry takeaway customers. The market is growing rapidly as more people order food to their door, via websites and apps. This sector tends to be pretty resilient when times get tough, as people trade down from eating-out to eating-in.

Rightmove is exposed to the UK housing market, which has shown signs of weakening lately. However, the vast majority of its revenues come from estate agents’ subscriptions. The ‘must-have’ nature of a Rightmove subscription, combined with the on-going shift from print to digital advertising, means the business has continued to prosper, despite its customers coming under pressure since the referendum.

XPS Pensions administers defined benefit pension schemes. Demand for XPS’ services has tended to be linked to regulatory changes (more regulation = more work for XPS) and depends very little on the economic backdrop.

The only company in the table that we believe is significantly exposed to the UK economy is Close Brothers, the specialist UK lender. If the economy turns down, more people could start defaulting on their loans and profits will likely fall.

However, in the past, Close Brothers has proven adept at capitalising on downturns, holding its dividend flat during the 2008/09 financial crisis. Should the UK economy take a turn for the worse, we would expect the share price to fall, but the dividend to be maintained and the business to emerge stronger with time. Remember this is our opinion and isn’t guaranteed. All dividends are variable and should not be seen as a guide to the future.

Income focused

Our UK Income fund holds more domestic names than the Growth fund. This is because a number of domestically-focused businesses are out of favour and are offering generous dividend yields. However, in most cases they are not particularly exposed to the UK’s economic fortunes. We hold just short of 5% of the fund in utilities through our positions in Pennon and National Grid.

Providing we continue to use water and electricity after Brexit these should be fine, although we accept there is regulatory risk with these names, particularly if a Corbyn-led government materialises. Sentiment towards these companies is depressed and their yields are high which we believe helps compensate for this additional risk.

In the Real Estate Investment Trust sector, we own Tritax Big Box which leases large warehouses to companies like Amazon and Tesco. The weighted average unexpired lease length is over 14 years meaning the business enjoys very long-lasting income streams. Primary Health Properties, which we also own, benefits from similar lease lengths and most of its income is backed by the UK government, so its dividend should not be impacted by a UK downturn although of course there are no guarantees.

We do own some businesses that are more sensitive to the UK economy, such as Lloyds Bank and pub-company Greene King. But these are very much the exception rather than the rule and offer very chunky dividend yields to compensate during uncertain times.

Areas we’ve avoided

In both funds, we’ve avoided businesses that are very dependent on the UK’s economic fortunes, such as housebuilders, general construction and general retail. This is not because we’re predicting a bad Brexit outcome, but simply because these companies have little control over their own destiny and don’t fit our investment process.

Summary

The UK’s situation is highly uncertain and this will have an impact on some UK companies. Brexit will, very likely, continue to dominate the headlines. However, we have not attempted to position the portfolios for one outcome or another and we are sticking to our investment process. The businesses we own are, in the main, internationally-diversified and/or less dependent on the economy than most. Whichever way the Brexit negotiations go, we are confident our holdings can prosper in the long run.

Please note the author or his connected parties own shares in Tritax Big Box.

More about HL Select UK Growth shares

HL Select UK Growth shares Key Investor Information

More about HL Select UK Income shares

HL Select UK Income shares Key Investor Information

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