HL Select UK Income Shares - Q4 2024 Review

James Jamieson - Fund Manager

18 February 2025

Market review

UK equities delivered a total return of -0.4%* in Q4. During the quarter we saw both the re-election of Donald Trump and the delivery of the first budget by the new Labour government in the UK digested by investors. Whilst the market’s overall movement might have been modest, there was plenty of volatility which seems to be an increasing feature of markets presently.

Early announcements have led to higher bond yields on both sides of the pond. In the US, the Republican party winning the lower and upper houses (along with the Presidency) means that Donald Trump’s inflationary policies are more likely to be passed, resulting in upward pressure on borrowing costs. Similarly at home, the budget has resulted in rising yields given it contains more borrowing and less growth than previously anticipated. The difference being that the UK has much less headroom to absorb the increased cost of borrowing. Financials were the best performing group led by significant outperformance from the banks as they continue to see strong earnings revisions and re-rating thanks to rising yields and a decent enough economic outlook.

Global growth expectations have softened a bit. November PMIs (the main proxy on economic activity) were little changed, and despite very substantial stimulatory initiatives being announced in China, the package under-shot expectations. It is fair to assume they are holding back some ammo in order to be able to respond when the new US administration takes office and begins firing their Tradewar policies at them. This weighed on the Materials sector which is highly geared to Chinese demand. Healthcare was also weak due to an unrelated issue in China centred on AstraZeneca (see Stocks Review below). Representing over 6.5% of the FTSE All Share, this had an impact on the index.

Fund review

The fund delivered a total return of -2.4% during the quarter. With an income strategy focused on long-term income streams and an investment philosophy that centres on quality businesses, it was likely that the fund would face a headwind given the march back up in bond yields. This has been the case for some time and subsequently short duration income (i.e. high visible income this year, even if not sustainable beyond) and the Value style (i.e. stocks that are optically very good value, irrespective of their future prospects) continue to lead.

Under the bonnet, IT made the strongest contribution to sector-level attribution as stock selection worked well and the fund has an overweight allocation to the group. Principal detractors are similar to the market with both Materials and Health Care proving a drag for the same reasons outlined in the market review. Rising bond yields impacted Real Estate where we are overweight. The stocks review fleshes out many of these trends. There were no major changes to holdings in the period.

Total Return (%): Fund v Index V Peers

Stocks review

The winners

HSBC

Along with most of the banks, HSBC had a strong run. Higher yields coupled with contained defaults and no recession is the right setup for lenders to perform. Furthermore, those with an investment banking franchise (like HSBC) enjoyed additional support on expectation of better deal and trading activity in 2025. Its Q3 update came in ahead of expectations, while the capital position also beat expectations. The new CEO announced a new simplified corporate structure along with various cost saves; nothing too radical and as expected. All in all, it was a good quarter.

SAGE

The turn out here is really all centred on the full year results update which was very strong, especially profitability and cash conversion. Management also announced guidance which was ahead of expectation, along with a new buyback. This was all very well received as investors were reminded that the company can grow whilst also delivering strong cash returns. To us the price action is pleasing but in reality nothing has really changed. Instead, it demonstrates the volatility at play and a lack of appetite to commit until it is presented in the numbers. This creates long-term opportunities but makes for uncomfortable investing short term.

Games Workshop

An excellent outcome from one of our highest conviction holdings. This is one of the least researched companies that communicates less to the market than any company that we cover, so it was an unusually eventful quarter. While we don't anticipate management to change their ‘focus on a day job’ attitude, analyst coverage could well increase having been promoted to the FTSE 100 in December. The H1 trading statement materially surpassed expectations. The core revenues from product sales continued to come through well which is especially impressive given a tough comparator in the previous year. Licencing revenues were also a big beat thanks to strong video game sales from the recently launched Space Marine 2 title.

In addition to the very satisfactory operational delivery, the most important development of all was the announcement that they have reached a final deal with Amazon Studios to create films, TV series and affiliated merchandise based on its Warhammer 40K universe intellectual property. While it will take time to materialise and flow through in the numbers, we believe that the deal will drive licencing revenues and raise awareness for the franchise, in turn driving core product sales as well. This exclusive agreement ratifies a core part of the investment thesis and where we see considerable upside to the Valuation medium term.

Compass

Expectedly good full year results, combined with confident management outlook and tone confirms the stock’s status as a quality compounder. The detail suggests an acceleration on various fronts, so exit momentum into the new financial year looks decent. The financial guidance appears conservative to us and we expect a new buyback to be announced at the half year results which could enhance full year earnings.

BAT

With macro uncertainty abounding and the Value style in vogue, the stock has continued to re-rate. However, the micro picture has continued to evolve negatively. Settlement was reached on the Canada litigation, but the company are yet to publish the financial impact. On our work this is an ongoing earnings reduction. Additionally, there have been various negative regulatory developments. The full year trading statement shows further share loss in the legacy combustibles business, with next generation products hampered by imitation products. We now see less value in the proposition and have been using strength to reduce the holding.

The losers

AstraZeneca

Last quarter it featured due to pipeline readouts. Weakness this time is ascribed to an opaque situation playing out in China that has raised concern about its ability to realise the full potential there. While the country only represents circa 13% of group revenue, it is materially more important to the future with growth tracking nearly +20%. A strong Q3 update provided limited support.

The story focuses on a corruption probe concerning certain oncology drugs, with the China Head and several other employees being detained by the authorities. An initial vacuum of information, misleading media information and a volatile market resulted in big moves. We can see some impact with local hospitals ceasing purchases of certain products pending the outcome. However, the local regulator has subsequently approved new drugs suggesting that its future is not in jeopardy. We believe the issue is over discounted and continue to maintain that the pipeline is undervalued.

Experian

It is hard to determine a clear cause of the recent weakness. The valuation had reached the fuller end of its historic range after a strong run. But as we have previously said it is now a better, broader business that merits a higher rating. Maturing investments should also see increasing growth and returns in the future. Our assumption is that higher yields and hawkish commentary from the US Federal Reserve has pushed out investors' short-term expectations for a US credit cycle recovery. H1 results were strong, with pick-ups observed in the detail. We remain constructive.

Persimmon

From top of the class to bottom of the class quarter on quarter. Like Tritax below, Housebuilders are negatively correlated to bond yields given that mortgages are a key driver of property demand, so it is not surprising to see a weak quarter. The Q3 trading statement also raised alarm on mention of build cost inflation returning which the market then chose to extrapolate aggressively. Although the setup has moved negatively in the very short term, we maintain that the medium term outlook is better than it has been for a long time.

Rio Tinto

As mentioned in the market review, macro factors resulted in weakness among the Miners and Rio was no exception. In terms of company specifics, it was a busy period of communication including an uneventful production update and an investor day that resulted in a small downgrade to numbers. Of most note was a fairly significant acquisition of the lithium producer Arcadium for $6.7bn. Lithium is currently in the doldrums due to the slowdown in electric vehicles so the countercyclical deal makes sense. The company also sanctioned $2.5bn of capital expenditure to expand lithium production capacity at its Rincon site.

Tritax Big Box

Real Estate is treated as a geared proxy for bond yields, irrespective of the fundamental value contained within the business. As a result of the recent march up in yields, the stock has de-rated aggressively. Its size and liquidity and the absence of updates from the company won’t have helped. Although frustrating we are not concerned and continue to see significant value.

The outlook

Big events have passed and by far the biggest outcome is known: that Donald Trump has taken up the US Presidency and that the Republican party now hold a majority in both the House of Representatives and the Senate (aka the ‘Red Sweep’). What we don’t know is how much of the hyperbole will stick, although the Red Sweep does increase the likelihood of making their initiatives a reality. While the range of outcomes is very wide, Q1 should reveal the majority of what is actually intended, with the remainder of the year seeing the work-through. Markets are predominantly driven by expectations around inflation, interest rates and growth. Below we draw out the three major topics that will determine these forces in 2025. Unlike the start of previous years where the high uncertainty was ascribed to the disruption wreaked by COVID, today the subject focus has changed with all three centered around the new US administration.

US domestic policy is important because many of the companies we invest in have significant US exposure. Furthermore, it determines the global appetite for risk given the dominance of its economy and capital market. Trump’s rhetoric has been contradictory. Many of his key policies such as deregulation and tax cuts are inflationary, and put upward pressure on bond yields (as we are seeing). But this hurts Joe Public who he purports to serve and can damage real growth (i.e. net of inflation) which is at odds with his pledge to invigorate growth. Our gut says that the inflationary deterrent will limit what actually comes to pass and part of the reason we believe interest rates are nearish their peak. We don’t expect the newly formed Department of Government Efficiency (aka ‘DOGE’) to deliver anything like its intended $2 trillion of cost cuts, but even a portion would be deflationary.

US foreign policy harbours the other two big issues for the year ahead. Firstly ‘Tradewars’ were integral during Trump’s first term and tariffs are a core topic this time around. Anecdotally only a fraction of what was promised previously came to be and had less of an impact on growth than economists had anticipated, although the headline risk during the duals can be painful for risk assets. Given tariffs can be inflationary, the extent of US action may be limited by the disincentive of stoking domestic inflation (as per our point above), especially as vulnerable countries now have a playbook and are better prepared to defend. Being the main antagonist, China’s response is key.

As leader of the free world, the US is very instrumental in determining both instigation and resolution of conflict. Trump has spoken extensively on his want to end the Ukraine war. This has major bearing on European fiscal policy, commodity prices and a peace dividend (for growth) short term, with even more profound and lasting implications for the geopolitical world order. The major question is how Europe respond if the US withdraw their support. The consensus among experts is that Europe do not have the Euros to continue if the Dollars stop flowing. The risk to this view is if a new government in Germany were to lift the fiscal debt brake and direct spend on rearming in order to defend the future of Europe (and in so doing stimulate the economy).

In summary, inflation expectations rising and growth expectations falling has called into question the consensus for a ‘soft landing’ (i.e. the scenario where central banks slow down economic growth to curb inflation but without triggering a recession). At this point we continue to believe in that prognosis and will be following the above three variables closely.