HL Select UK Income - Q2 2024 Review

James Jamieson - Fund Manager

5 August 2024

Market review

The UK stock market delivered positive returns of 3.7% over the quarter, despite the unexpected announcement of a general election halfway through the period. The result duly arrived just after the quarter end and held few surprises overall, given the state of polling throughout the campaign.

Politics aside, the markets were influenced by the ongoing debate about whether interest rates would fall and if so when, and by how much. The Bank of England draws on economic evidence when it makes these decisions and so far, the evidence is mixed. Inflation has at least returned to the 2.0% target level, far below the 2022 peak of 11.1%. However, the devil, as always, lies in the detail. Goods prices are currently falling, by 1.3% p.a. at the last count, but Services price inflation is still some 5.7%, having only just rolled over from its peak rate. This twin-speed economy does not make the Bank of England’s decision any easier. So far it is sticking in the pack of other major central banks and not budging.

The best returns amongst the major sectors came from Health Care and Financials (notably the Banks), whilst Utilities and Consumer Discretionary were the laggards. Weakness in the Utilities was prompted by a surprise rights issue from National Grid which caused contagion across the sector about future funding needs. This came at a time when concerns about tighter regulation and possible financial penalties for Water companies with poor pollution outcomes were already unsettling investors.

Sherlock Holmes explained his solving of The Hound of the Baskervilles by highlighting that the dog had not barked in the night. This last quarter was remarkable too for the lack of barking. For much happened that could easily have worried markets. France has entered a period of intense political instability, dependent upon coalitions between parties who would typically cross the road to avoid exchanging pleasantries. France matters because it lies at the heart of the EU, our most important trading partner. The EU’s own elections showed a shift toward the right, which of course prompted the French poll. The Israel/Hamas conflict is still hot and capable of spreading, with exchanges between Israel and Hezbollah in Lebanon seemingly picking up. Meanwhile Ukraine and Russia seem a long way away from any sort of accord.

There are signs of slowing in the US economy. At the moment the market is taking the view that this matters not, if it gets worse the Fed will simply cut rates and off we go. Markets have not traditionally treated slowdowns, let alone recessions, with equanimity. Why should this time be different? Perhaps the most curious incident of all is the incredibly narrow leadership of global markets. A small number of AI-driven stocks are leading Wall Street and Wall Street is leading the world. At some point AI has to be seen to be powering the performance of those who adopt it.

Fund review

The fund delivered a total return of 3.2% over the quarter. The portfolio is tilted toward areas like technology and companies with digital business models in other sectors, like RELX and Experian. During the quarter, within the overall sector movements there was a rotation by investors in favour of more traditional, Value-driven sectors like Banks.

Our style is to favour those businesses that we believe can keep compounding their earnings far into the future. These growth stocks are rarely found on low ratings, so when markets become value-conscious our portfolio can face headwinds. Our approach is not to shift course, but just concentrate on reviewing the businesses we hold to ensure they still have that potential to compound out into the future because for us, long-lasting growth is the best driver of value.

Stocks Review

The Winners

AstraZeneca rose by 15.7% over the quarter and because we have a substantial position, this added 1.2% to the fund’s value in its own right. As mentioned above, the group delivered an encouraging update mid-quarter that underlined the strength of their portfolio of drugs and the potential for their research pipeline to deliver future growth.

HSBC saw the announcement that its CEO, Noel Quinn had decided to step down after four years in the role. The market also learned that a major Chinese shareholder, the Ping An insurance group was looking to reduce its stake in HSBC. Those two events might have been enough to tip the stock lower, but the bank delivered a solid set of Q1 results which provided reassurance that underlying progress is good.

Shell’s stock price is often batted around by global energy prices. In Q2 these were pretty neutral, with a small rally in oil offset by weaker gas prices and refining margins. But Shell reported a very strong first quarter, which showed the group firing on all cylinders, including the all-important cash generation metric. The Group observed that oil demand, aviation fuel aside, is now above pre-pandemic levels. This underlines the energy transition challenges the world faces. For all the growth in renewables, demand for hydrocarbon fuels continues to rise regardless.

RELX enjoyed a strong quarter, returning almost 8%, but with few obvious catalysts for the move. Perhaps the market is better appreciating the group’s ability to increase the value it can offer through adding AI functionality to its data-driven offerings in areas from risk management to academia?

GB Group posted a strong quarter after releasing Full Year results that looked a little ahead of market expectations to us. Within the detail there is an acceleration in performance during the final few months of the year and the group made positive noises about the year ahead. GB have been cutting costs and they are lapping relatively easy prior year comparatives in the next few quarters which should make their growth and their margins more visible. We still view GB Group as well positioned within the digital economy – their data is critical for their clients' efficient operations in e-commerce and fraud prevention.

The Losers

Diageo continues to suffer from weak sentiment following its surprise downgrade due to Caribbean and Latin American weakness a few quarters ago. Indeed the group continues to be dogged by weak Tequila demand and their seems little evidence of any re-stocking by their wholesale customers. Market forecasts continue to drift lower, keeping Diageo under a cloud. But Johnny Walker keeps on walking. In our eyes, Diageo’s portfolio of brands remains hugely valuable and its cash generation capability is undiminished so we remain committed investors.

Sage is one of the UK’s leading Growth stocks and the current Value-led market is not an ideal backdrop for them. We felt their interim results in May were strong, but the lack of any acceleration in revenue growth was taken badly by the market. We viewed the resulting fall in the stock as an anomaly, Sage have created a large and growing book of software subscription revenues that will be highly cash generative for years to come. Their business is highly cloud-centric these days and incremental revenues should have a very attractive drop-through to profits, something that seems underappreciated by the market currently.

Ryanair has suffered turbulence, but remains airworthy to us. We have been surprised and a little disappointed to see the company’s expectations for fare growth trimmed repeatedly. Capacity in the airline sector was thought to be quite tight, which would normally translate through to firm pricing. In that environment we had thought that Ryanair’s structural advantages as the lowest cost, largest scale operator in European aviation would stand it well. Instead it appears that consumers are calling time on rising air fares. To us Ryanair remains the best-placed operator and periods like these have tended to play out in its favour eventually by discouraging the more marginal players from adding to capacity. For now though, the flight is looking a little choppy.

GSK suffered a setback in their legal fight over their former Zantac drug. We’ve written about this before, but essentially there are a number of individual and class action suits in the USA, alleging that Zantac can cause a variety of cancers. A case in Delaware went against the company, allowing a plaintiff to proceed to court. GSK are appealing and so it will rumble on. In many previous courts, GSK’s argument that there is no scientific basis for the claims has prevailed. The company also saw a regulatory setback when a US Advisory committee limited the group of patients who are deemed to benefit from GSK’s new RSV vaccine to a smaller number than previously. We are maintaining our position at its current modest level whilst the Zantac litigation arguments play out.

National Grid unveiled an unexpected, and large, rights issue to pre-fund investment into the grid as they reshape it to cope with the energy transition. They maintained the amount of dividend they will pay, but with more shares in issue, that represents a cut in the dividend per share, a real disappointment for many holders. On the plus side, the growth in the business feels more tangible in years to come and the group will be less challenged if interest rates do not fall as far or as fast as the market expects. We took up our rights, given the growth we expect Grid to deliver.

The outlook

The UK election has seen Labour swept in with a huge majority, even though their share of the vote was little changed. In France, at the time of writing, no-one is quite sure who the government will be. In the wider EU elections, voters moved to the right, but not decisively so far. Whilst over in the States a rising clamour was calling for President Biden to step down from the Democratic nomination, now confirmed in the latter part of July.

The new UK government said little of substance before the election, proving the old adage that Oppositions do not win elections. Instead, governments lose them. However, Labour has said that core tax bands and rates will not be changed. If they have plans to raise significant amounts, they are yet to share them. That ought to help keep consumer confidence up, although the ongoing impact of mortgage refinancing will continue to hurt for a while longer.

We have seen some less than encouraging data on jobs, not least a recent trading update from Page Group, the employment agency that talked of lower rates of hiring in pretty much every major economy. Central banks seem to want to know that inflation is firmly buried before they cut rates. Market expectations are now only for limited cuts later this year. The UK and other major global economies have done well to get through all that has been thrown at them in recent years. Neither surging interest rates, pandemics, energy price shocks, nor wars in the Middle East and Ukraine have led to recessions. The unpredictable lags of monetary policy means these could still come. But central banks have regained their armory now that interest rates are high. We don’t know for sure when interest rates will fall, or by how much. But over the next year or two we do expect them to fall and for bond yields to move lower in response.

Over the quarter we bought into Kainos and exited Unilever. Its defensiveness has served us well at times of stress in markets, but the group is still struggling to get its portfolio of brands firing on all cylinders. One of our concerns is the degree to which Unilever and other major branded goods companies have pushed pricing ahead in recent years, making some of these companies potentially less resilient in years ahead.

Globally, markets have been led higher by leading AI players, like Nvidia in the USA, which briefly became the world’s most valuable company in late June. The UK is relatively unexposed to physical AI technology production, but we are an extremely IP-driven economy. AI will impact us via how businesses that operate or are listed in the UK, deploy the technology as it becomes available to them. It seems reasonable to us to think that those who run efficient businesses that effectively use Intellectual Property to create value for their shareholders are likely to be better at deploying this new technology than those who do not.