HL Select UK Growth Shares - Q2 2023 Review

James Jamieson - Fund Manager

20 July 2023

Market Review

Markets began the period strongly but were soon knocked off course by concerns over whether the US Senate would reach agreement over a resetting of the Debt Ceiling. As usual, a last-minute compromise emerged and the risk of a US debt default was averted. The importance of this issue being resolved each time it emerges cannot be overstated. Even a technical default swiftly corrected could still have serious repercussions around the world, because US debt government securities are widely used as high-quality collateral to secure borrowings by third parties. Compromise by the two sides of Congress is inevitable as a result.

As the quarter developed, more evidence emerged of ongoing resilience in economies and the stubbornness of inflationary pressures. This in turn led to higher interest rates, with expectations of further hikes to come. UK base rates now stand at 5.0% with most commentators now expecting multiple further increases. Inflation remains high, with the Consumer Price index at 8.7% in May.

The overall market return for the quarter was -0.5%. Within that result, Financials stocks, and Banks in particular, led the way. Higher rates are increasing banks’ interest income, whilst still-strong employment is limiting bad debt charges, even if the economic clouds are darkening. Bank earnings could become more pressured over time, as more households see fixed-rate mortgage terms come to their end and higher rates bite into disposable incomes.

With concerns over the global economic outlook growing, it was no surprise to see commodity producers’ stocks performing relatively weakly. Somewhat less predictable was the weakness in Consumer Staple stocks, normally seen as something of a haven in troubled times. We put this down to the impact of high inflation that could potentially lead to volume weakness. At its simplest, consumers may spend more money buying fewer goods.

The poor performance of the Materials sector is unsurprising given a muted Chinese post-COVID recovery, whose demand for metals and minerals is critical for their market prices, which in turn impact the profits of Materials producers. Profit warnings from Chinese companies compounded the picture, coupled with reports of de-stocking across industrial supply chains. As we flagged last time, the strength of companies’ guidance would be an important factor for the year ahead. So far we see the tone of guidance as quite precautionary, and the upcoming interim results season should provide a clearer picture.

Fund Review

The portfolio delivered a total return of 1.1%* in the quarter. Our focus on quality businesses served us well. With an uncertain outlook, our preference for companies with modest borrowings and good revenue visibility proved helpful. Higher interest rates remain a headwind for the valuation of quality businesses. Hopefully with expectations of the peak in rates becoming closer, this impact will become less meaningful going forward.

Given this, Industrials and more specifically our Commercial & Professional Services exposure, did well. Experian was especially strong (see Stocks Review). As touched on in the Market Review, Financials and Banks were also positive, notably HSBC (see Stocks Review). The main detractors were Materials, with Rio Tinto suffering (see Stocks Review). While demand-destruction caused by inflation hit Staples in general, BATS and Diageo also faced some stock specific issues (see Stocks Review).

The impact of Artificial Intelligence (AI) has been grabbing headlines ever since the launch of Chat GPT a while ago. There are no pure-play companies of any scale to invest into in the UK market. But that is not to say that AI will leave the investment world untouched. Far from it. We expect widespread adoption of AI technologies across the board. It is after all an efficiency tool. AI can be used to improve service levels, lower costs or accelerate research efforts to name just a few applications. It is not a new concept, but its pace of applicability is accelerating. There will be winners and there will be losers. When we look at the portfolio we see more opportunities for our companies to boost their capabilities than we see threats. Time will tell, but we expect that like other generations of technology before it, AI will grow the pie, not shrink it.

Total Return (%): Fund v Index v Peers

Stocks review

Winners

HSBC was added to the fund at the start of the year. Any given period contains a lot of news flow for a company of this size and while this quarter was no different, there are two developments worth mentioning. The first was results which beat expectations. While no revision was made to management’s expectations for the full year, guidance is now looking conservative which led to upgrades. Resumption of quarterly dividends and a new buyback also help buoy the stock. The second was the AGM outcome which saw the majority of investors reject one large shareholder’s demands to break up the group. It is a complex topic but the main point is that the conclusive vote removes the grumbling noise that serves as a stock overhang.

Experian featured in the losers list last quarter with investors worried about the impact of demand rolling-over in the US which is an important market for them. Full year results and the 2024 outlook published in May allayed these fears, with the operations displaying more resilience than had been anticipated and the market being reminded that the structural growth opportunities they are exposed to can partially offset the inevitable forces of the cycle. No doubt reversion helped as well.

Adobe produced strong operating results, as is so often the case with those in the Winners camp. Specifically their Q2 results were better than consensus expectations, with Q3 guidance also ahead of consensus. We care about operational delivery more than anything, so this was a good and encouraging update. But the share price strength is really attributed to the excitement around AI, with the company deemed to be a beneficiary. Indeed, management even spoke of monetizable tools being rolled out this year. On a less positive note there have been some negative anti-trust developments concerning their proposed multi-billion dollar acquisition of Figma, although the company maintain it will complete by year end.

Compass embodies the re-appreciation of defensive growth that was touched on in the previous section. Excellent H1 results (beat and raise to the outlook) corroborate these credentials and confirms why this is a top active position in the fund. It also served to remind how attractive the cash dynamics are, with an interim dividend declared ahead of expectations and a new buyback announced. Underlying trends in the outsourcing market continue to look attractive.

LSE saw some encouraging developments in the quarter but nothing major. A decent trading statement, a significant contract win and a placing of LSE shares by Blackstone, one of the original Thomson Reuters vendors, was well received by the market. Like Compass we think it is their profile that resulted in the stock continuing to rerate.

Losers

BP featuring is not for operational reasons. Energy stocks have been weaker in general as the oil price has come down on US recession concerns and a lack of offset from the softer than anticipated Chinese recovery. BP was also hard hit after declaring a smaller share buyback than had been expected, despite having a very clearly articulated mechanism that determines its level. No surprise to us, but such is the market we currently find ourselves in. We think the market underestimates both the tightness in the commodity and the will of OPEC+ (most notably the Saudis) to maintain a high price.

GB Group has frustratingly reappeared here. Despite producing satisfactory results for the full year and operating guidance for the year ahead, downgrades to earnings have followed on a higher cost of debt and currency translation effect. Tighter liquidity conditions have reduced the appetite for smaller companies, with small caps underperforming larger caps for some time. GB is very much afflicted by this and while we can see significant value in the shares, the stock needs to demonstrate growth to be rewarded.

BATS (British American Tobacco) has faced the double negative of poor sector sentiment and a lack of interest in the story after they paused the buyback last quarter (you will notice a common theme around buybacks by this point in the update) in order to reduce leverage on the balance sheet. We agree this is the right thing to do. But operational momentum has been sub-par, especially in the important US market, which precipitated the CEO suddenly stepping down. From our perspective, the jury is out. The new management team should serve to reinvigorate the delivery, so we wait and watch progress closely.

Diageo shares similarities to BATS, a weak sector backdrop and sudden change of leadership. Although in their case, the late and highly respected CEO sadly passed away unexpectedly, and the near-term challenges faced by the business are less a making of their own, but instead a post-COVID normalization in the US. There have been other unforeseen negatives including a lawsuit relating to the stewardship of one of their tequila brands and exposure to the Capita cyber breach via their pension fund. It has been a perfect storm and we view their world-leading brand portfolio as undervalued.

Rio Tinto has inadvertently been touched on many times above. There is nothing of note concerning the company itself. Performance has been a function of worries over the course of the economic cycle and China’s underwhelming recovery, causing price weakness in the underlying commodities that they sell. It remains our preferred exposure to the mining sector.

Past performance is not a guide to the future. Source: Bloomberg, 31/03/23 – 30/06/23.

The outlook

The UK’s embedded core inflation is an issue on many levels, but the consumer has continued to defy the odds and remained robust. While counterintuitive, it makes sense for the same reasons outlined in the Market Review that outlined why borrowers remain resilient. Pay rises have now come through and while life is more expensive, the big cost that is rising mortgage repayments has yet to be felt thanks to most homeowners being on fixed rate agreements. In other words, people are better off than they were before and while these dynamics will change next year when the fixed terms begin to expire in earnest, the set-up is good for now in related areas of the market.

During the second quarter, new positions were established in the convenience food retailer Greggs and OSB Group, a lender to professional landlords. Both of these reflect the brighter spots specified above, each having credible growth strategies that we believe will stand up through the cycle even when things get harder. Meanwhile the shares look good value to us as a consequence of the smaller company’s discount mentioned in the Stocks Review, providing a great opportunity to gain exposure to these high quality and well proven operators.

Outside of the market cap trend and sticking with the subject of valuations, equity risk premiums (the extra return investors demand for taking the risk of investing in stocks) appear too low and in our opinion do not capture the appropriate level of risk faced by markets. While some downside to earnings is reflected from lower growth, there is little accommodation of the impact from reduced liquidity which will hit sentiment and earnings, let alone the second order shocks that can become of that. Aggregate volatility readings are very low (suggesting investors are relaxed). Experience tells us that change can come very swiftly. If, as we expect, economies slow from here, change does indeed look increasingly likely.