HL Select UK Income Shares - Q3 2023 Review

James Jamieson - Fund Manager

10 November 2023

Market review

Inflation expectations and the yield curve continue to be the key factors influencing how people feel about the economy and the value of assets. In simpler terms, these two things have been the main drivers of the financial market's mood. Not much else of note happened in the third quarter.

To explain a bit further, the yield curve tells us what people think interest rates will do in the future and how safe they think borrowers are. Right now, much of the talk has been about interest rates going up to fight inflation and how long this will last. While inflation is slowly getting better, there are worries about it going up again because higher oil prices are on people's minds.

Lately, people have started talking more about something else: the huge amount of money the government needs to borrow to pay for its spending plans. This is a substantial change in the conversation. Central banks can quickly change interest rates when the economy and inflation change. They can also adjust the amount of inflation they want. But governments can't easily undo their spending commitments, so when people think they might have trouble paying their debts, they demand higher interest rates.

The conflicting information and changing opinions about all this made UK stocks quite volatile in the third quarter, but in the end the FTSE All Share index rose by 1.9%* in the period under review. The focus on inflation saw a shift towards "value" stocks that helped the UK market, which has a high number of these types of stocks. So, sectors like Energy and Materials did well. On the flip side, companies focused on growth and those with larger debt did poorly because both groups suffer when interest rates go up. This meant that sectors like Consumer Discretionary and Utilities didn't do as well.

Fund review

Our fund returned 2.3%* in the third quarter. Just like the overall market, the performance during this period was a bit all over the place. Stock selection benefitted from high dividend paying companies typically carrying a value bias, while the big rally in Materials hurt due to our underweight position.

Energy was by far the biggest single contributing group. This was because, as mentioned in the Market Review, commodities that don't take long to pay off do well when interest rates are going up. The rising price of oil also helped, as we'll discuss in the Stocks Review section below. The next strongest area was Real Estate. This will come as a surprise because it was not an area of positivity for the market. Instead, it can be attributed entirely to Tritax Big Box REIT which is discussed in the Stocks Review below.

As was the case for the index, our Utilities performed poorly. Higher rates mean an increased cost of debt which weighs heavily on Utility companies that are highly leveraged. In addition, Water companies had a very weak period which is covered off in the Stocks Review. Financials also dragged for stock specific reasons, as explained below.

Total Return (%): Fund v Index v Peers

Stocks review

Winners

BP and Shell are heavily influenced by the price of oil. Our investment thesis is centred on a strong oil price, as we've explained before. What gives us even more confidence in our short-term outlook is that US oil reserves are currently very low. With an upcoming election and high oil prices, it's unlikely that President Biden will significantly increase these reserves, as doing so could risk fuelling inflation during his campaign.

In addition, BP's CEO resigned due to governance issues related to undisclosed romantic relationships with staff members. This was the right action to take, and while it does introduce some uncertainty, we believe that the company's strategy and execution will continue smoothly. This is because the former CFO, who is now acting as the head of the company, has been closely involved in the ongoing changes and is well-acquainted with the business.

RELX appears here due to specific factors related to the company itself. We always prefer to focus on these "bottom-up" reasons for better performance, as they align with our core Select philosophy and purpose. In the case of RELX, we've seen that sustainable growth has increased for the company, partly due to the rapid development of Artificial Intelligence (AI), particularly in their Legal division. This has led to higher earnings and an improved stock valuation. Interestingly, earlier in the year the stock price had dropped due to concerns about the impact of AI, but these concerns seem to have been proven wrong.

Furthermore, in the journals business, RELX has struck a deal with a group of German science organisations to provide open access. This resolves a longstanding dispute that had been affecting the company's shares.

Tritax stood out from the Real Estate pack. Despite the rates environment that proved such a headwind for the sector deteriorating further in Q3, there is always a point at which fundamental value support kicks in for high-quality companies. Given the company’s H1 update was in line with expectations, it’s fair to assume that this was the case for Tritax which enjoyed a number of upgrades from broker analysts. The increase in the interim dividend declared suggests management are confident. Pleasing as a return to company specifics may be, their correlation to yields remains and the full value will not be realised until the backdrop reverses.

Cranswick's outperformance is a function of two things. Firstly, they put out a strong Q1 trading statement, with management citing outcomes ahead of previous guidance. This is against an industry in turmoil, so a clear demonstration of our 'strong getting stronger' thesis coming through. Secondly, defensives like this did well and Cranswick especially so.

Losers

Experian is a company that focuses on growth, but as we discussed in the Market Review, this category of stocks didn't perform well during this period. During the third quarter, Experian released a trading statement for Q1 which was satisfactory, but it didn't impress investors as much as they had hoped. This has been a trend we've observed for some time – stocks tend to get punished by the market unless their management consistently raises their future expectations. This is likely due to increased anxiety among investors and a desire for more certainty regarding short-term growth prospects. We've looked at the competition and we believe that, despite increasing competition in both their consumer and corporate markets, Experian is in a strong position to come out ahead.

Diageo is back in the picture, and it's been a bit frustrating. While their full-year results were okay, the fact that they didn't give any guidance for 2024 didn't win them much support, leading to continued lacklustre performance. We believe the soft sales volumes in the U.S. are temporary and given the destocking process, it's challenging for the management to provide clear financial guidance right now. However, they did confirm their medium-term plans, which align with our outlook.

The new CEO did a good job in her first update, and our initial impressions are that she's the right person to lead the company forward.

OSB has been quite disappointing. It's a new addition to the portfolio and before we invested, we did a lot of research including meeting with the company. They assured us that the trend of mortgage customers switching to a different rate after their fixed term wouldn't be a problem. Shortly after we finished our analysis and started buying the stock, they issued a profit warning for this very reason (customers refinancing faster, leading to lower earnings for the bank). This raises concerns about how the company is managed and how they communicate with investors. As a result, we won't be investing a large amount in this unit. However, in our opinion the stock was good value even before this happened, so we're holding on to it for now.

Pennon is a Utility. As discussed above, this group performed badly because their regulated business models enable company balance sheets to carry a lot of debt, so the rising cost of debt impacted earnings estimates. Furthermore, the water sub-sector fared the worst due to very negative sentiment around sewage overflows and pollution. This subject has been ongoing for some time but worries around the regulatory response have increased. The fear is that the cost of the remedies imposed may place company dividends in jeopardy or require equity issuance, neither of which we subscribe to in the case of Pennon.

National Grid was afflicted by the same cost of debt forces as the rest of the Utilities. Beyond that there is little to add.

Past performance is not a guide to the future. Source: Bloomberg (30/06/23 – 29/09/23)

The outlook

The volatility and lack of direction in markets can partly be explained by the difficulty in determining where we currently are in the economic cycle. While this was never an easy undertaking and no two cycles are the same, it is especially complex right now because COVID dislocated many of the prior trends, while the policy response has brought about a new monetary and fiscal regime. Even after a year or two of normalisation, the judgement isn’t much easier. We must try no less.

Stripping back the noise and confusion, one thing seems clear: that the indicators of business conditions are gradually seeing slowing momentum. Simultaneously, lesser followed data such as bankruptcies and corporate distress are accelerating. This evidence suggests that we are more likely to be in the latter phase of an economic cycle than the early part, and anecdotally the market seems to have moved to this thinking during Q3. Typically, after the latter phase of a cycle, comes a recession.

We still don’t believe that the cost of equity reflects the risk of a downturn. This is no change to our prior view with the fund positioned to this end. As such it was a quiet quarter with trading limited to minor setting of the sails in terms of position sizing.

China upscaling their stimulus efforts could see a pickup in growth, although we don’t think that the targeting or magnitude will be enough to change the global outlook meaningfully as it did historically. Bond vigilantes demanding higher yields to fund ballooning deficits would exacerbate a downturn should they successfully catalyse a credit crunch and force governments to curtail spending plans.