HL Select UK Income Shares - Q1 2024 Review

James Jamieson - Fund Manager

25 April 2024

Market Review

UK stocks delivered another good quarter, posting a +3.6%* gain. The fourth quarter’s optimism that interest rates had peaked was confirmed in the new year, boosting bullish sentiments in the market. Hawkish members of the Bank of England’s Monetary Policy Committee changed their voting (from hiking to holding) and the Swiss National Bank was the first major central bank to cut rates, after pricing data continued to confirm that inflation is easing. Meanwhile, attacks on shipping in the Gulf by Houthi rebels have driven up logistics costs and geopolitical conflicts have sent the oil price higher, but these actions have not dented confidence that inflation is on the wane.

While the rudder of the market is singular and seemingly simple, the reality is of course complex and messy. For equity sentiment to remain firm, it requires a combination of inflation (and bond yields) moderating as we have seen, and also good economic growth data which we have also had. The relationship between these variables is kept in balance on a tightrope and when there is movement in any direction, opinion quickly changes about the outlook. The longer the good times ensue, the responses to changes become quicker and harder felt. This has been the story of the last few years and remains so. Rates may have peaked but as the quarter drew on, it became clear that their future profile was looking less like the Matterhorn and more like Table Mountain. Central banks seem determined to wait until they are certain that the inflationary threat has receded before they allow interest rates to fall.

Investors seem convinced that Central Banks won’t push economies into recession. With confidence in economic growth duly reinforced, the relatively cyclical Industrials and Financials sectors led the market higher. Especially the sub-sectors of Capital Goods and Banks within each. At the other end, Materials were poor as metal prices fell on concerns the Chinese economy will remain subdued and that Beijing’s attempts to kick-start demand won’t work. Utilities suffered from changing expectations on the timing of rate cuts to alleviate their high interest payments, while also being defensive at a time when risk is preferred.

In terms of new developments, the three-month period has been characterised by the return of corporate activity with a significant pick up in UK mergers and acquisitions (M&A). This marked change has been led specifically by strategic trade buyers - corporates buying their competitors or adjacent competencies, rather than financial actors who have been so active in recent history. This is partly a function of deal economics becoming less favorable for Private Equity buyers given the higher cost of debt financing, but importantly it is also a sign that there is value on offer in the London market.

Fund Review

The fund returned +1.6%* in the quarter. Selection was dragged by our Banks - more on this below and in the Stocks Review. January was positive as the market subscribed to the Goldilocks scenario outlined in the Market Review. In February these trends reversed as the cadence of rate cuts evolved. This proved especially painful for Income funds which are weighted to areas that are negatively correlated to yields. Subsequently, volatility also picked up through the period with earnings season adding to this. In March the breadth of participation extended to lower quality realms of the market.

As you would expect for a relatively concentrated portfolio, high level top-down fund performance is often explained by the individual bottom-up positions. Which is why the names featuring in the Stocks Review often reflect the summary observations cited in the Fund Review. In Q1, our Consumer sectors led by some margin. Unlike the market, Staples added the most value thanks to the stocks held but additionally aided by portfolio activity as we reduced exposure to this area. Discretionary was also strong for us, entirely as a consequence of owning the right names.

In contrast to the performance attribution posted by the Index, Financials were the main detractor in the portfolio by far. The reason for this is ultimately two of the Banks. See the Stocks Review for specifics on both. As touched on above, changing expectations of the rate cut timeline impacted sectors that are leveraged and thus whose earnings are sensitive to the cost of debt. Real Estate is one such area and was a weak spot given we are overweight.

Total Return (%): Fund v Index v Peers

Stocks Review

Winners

RELX is in the top set again. The company continues to deliver and a strong full year (FY) report and outlook for 2024 has seen further earnings upgrades. From our point of view, this was the quarterly update which confirmed they can sustain higher growth than pre-pandemic. We booked some profit as it is well up with events, but it remains the largest holding and we are sanguine on the full short-term valuation given RELX’s strong medium to long-term compounding credentials.

GSK has been the recipient of broker upgrades in recent months which have buoyed the stock nicely. There are many reasons cited for positivity. Our read is that the valuation had overextended to the downside and investors have found increasing comfort concerning the Zantac legal proceedings (which we have written on previously) and the affiliated potential damages. We agree on both counts. On the latter, two very important upcoming state cases in California were settled before going to trial which bodes well. FY results were strong across the board and new medium-term guidance came in ahead of expectations.

NEXT PLC’s operating performance is defying the softer consumer data trends. FY results were ahead of expectations and upgrades to forecasts followed new guidance. Meanwhile the notoriously conservative management team express that this is the best starting point for the year that they can recall in a long time. All great stuff, although it is now largely reflected in the valuation. What isn’t is the potential embedded in their Total Platform operation, which takes them from being a very well run cyclically exposed retailer to a value-accretive service provider and investor. Payback from said capital allocation decisions is beginning to come through and we remain constructive.

BP, as always, is largely governed by the oil price which has been strong, posting a circa +15% gain off the back of decent macro data and escalation in geopolitical conflicts. Although it could be argued that it is really just recovering what was lost in the previous quarter when worries over future oil demand dampened sentiment. Given this strength at a time when all important Chinese growth is subdued and the UK windfall tax on North Sea assets has been extended, there could be further support yet. The company appointed new management which removes uncertainty and means they can get on with delivering the strategy. The FY update was good, coming in ahead on cash returns and delivering an upward revision to the computation of future cash returns which is a core part of the thesis.

Experian is also up top yet again. In Q4 the stock’s strength was about the company demonstrating cyclical resilience in contrast to peers and its own history. This time their latest quarterly update further consolidated confidence as the results revealed acceleration in the consumer-facing business and share gains across various corporate-facing lines. With plenty of growth to go for and a great financial profile, the shares continue to offer value.

Losers

Close Brothers (CBG) had a deeply disappointing and frustrating quarter. In January, the UK regulator (FCA) announced they are reviewing the UK Motor Finance market, which represents approximately 20% of CBG’s loan book. The FCA is contesting how brokers were incentivized to sell these products from 2007 to 2021 and as such has launched an investigation, citing redress to customers as a potential outcome when they conclude the probe in September. The protracted proceedings, and the process of announcing a review at the outset without providing proper detail is hugely unhelpful for listed companies. Investors dislike uncertainty and a vacuum of information concerning an unanalysable situation in a smaller company like this renders the stock un-investible, explaining why the shares have lost half their value. Meanwhile the bank is delivering well operationally but this is an irrelevance at the current time. In response to the inquiry, management have enacted a series of initiatives to bolster capital. Potential remediation costs, which may (or may not) come could be significant. We have worked through various scenarios, which simply proved that a very wide range of outcomes is possible. When the announcement first hit we managed to sell some of the position and limit the damage. What remains has now diluted down and limits further impact as we await clarity later in the year.

Rio Tinto, like BP in the Winners section above, is heavily contingent on the price of the underlying commodities that they mine for. Consequently, the stock’s weakness this quarter is explained by their exposure to Iron Ore which represents 60% of the business and has retraced -30% on the failure of Chinese stimulus to shore up demand. Aside from that, there is very little else to say. Decent FY results and commentary that they are carrying the best pipeline in years bodes well for the future.

MoneySupermarket has undergone a derating. The FY update was marginally ahead of forecasts and the outlook broadly as expected. However the company has communicated that no improvement is anticipated in the year ahead from the Home division which was potentially a source of disappointment. As long-term investors we are sanguine given this is a phasing issue and see good value in the name given they are well placed to continue taking share in new verticals. Medium term conviction is also emboldened by the announced exit of Amazon who are folding after just fifteen months as they failed to disrupt the big incumbents.

OSB is the other bank alluded to earlier. After a very strong Q4, there is a degree of reversion in this outcome. Aside from that, what may have driven the extent of weakness is a bit of a mystery to us. FY results put out were solid, surpassing expectations in: the loan book, credit quality, capital and cash returns. So we assume that the guidance on loan growth and the interest rate earned on these loans disappointed the market. From our perspective, management are being prudently conservative in their aspirations given that we are early in the year and the market is highly uncertain. Either way the shares seem attractive, even if the outcomes materialised far below the guidance. The Close Brothers debacle won’t have helped sentiment towards smaller banks, even though they aren’t exposed to Motor Finance.

Pennon is back in the detractors camp having rolled over after the big rally in Q4, with the subject of sewage returning, given the very wet winter increases the likelihood of overflows. Furthermore there have been numerous negative references from the water sector this year - Welsh Water getting fined, the EA criticizing Pennon’s South West Water asset for inadequate management of drought projections in ’22, and the further unraveling of Thames Water. In terms of tangible developments within the operations, in January they acquired Sutton and East Surrey Water who provide water to E.Surrey, W.Sussex, W.Kent and S.London. The deal was funded via an equity placing, is EPS accretive in the first year and is a good addition to the business.

The Outlook

If the equity risk premium had fallen to a low level through 2023, it is now non-existent. The compression has been driven by improving sentiment, not fundamentals. A low cost of equity is not a problem in and of itself, and equities can extend further so long as earnings growth continues to come through satisfactorily. If it doesn’t, then the risk premium will rise and the stock market will correct. Likewise if there is an unexpected systemic event or inflation reaccelerates meaningfully. On the latter we are watching the oil price closely.

It was pleasing to see the fund unit price hit a new all time high in the past quarter. In light of the improving outlook for inflation/yields and our view of the world, we added two new holdings to the portfolio over this period: Ryanair and Rotork. The rationales for these purchases can be found on the website.

The UK regulators have been increasingly zealous for some period of time. We advocate the need for oversight and stewardship of markets, but the incidence of mandate creep and unnecessary interference feels to have crossed a line. The motor finance probe mentioned in the Stocks Review is one such example. Others have been announced from veterinary practices to housebuilding. This bothers us and is now an elevated risk consideration when appraising companies. It also exacerbates the de-equitisation trend as businesses choose to domicile in lighter-touch jurisdictions.

We are approaching a General Election, the date of which appears more uncertain than the likely outcome considering the polls. The Spring Budget has not shifted the dial and the polls have remained static. Labour, for their part, are allowing the Government to make their own mistakes whilst keeping promises minimal until they publish their manifesto. As a Financial Times commentator aptly put it: ‘Labour win elections when middle England are convinced they aren’t scary and voters are sufficiently worried about the state of public services.’ With the polls where they are, we see a Labour government as the most likely outcome. History suggests investors should not worry too much. Markets have thrived, or withered, under a variety of administrations and circumstances.