[Commentary] Slater Growth Fund – Interim Report for the six months to 30th June 2020

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Performance

Six months

1 year

3 years

5 years

Since launch*

Slater Growth Fund P unit class

-11.55%

+3.48%

+16.76%

+45.10%

+472.32%

Investment Association (IA) OE UK All Companies

-17.74%

-11.02%

-4.91%

+11.95%

+135.38%

*A unit class launched 30 March 2005

Overview

The six months to 30th June 2020 was a tale of two contrasting calendar quarters.

Investors panicked at the end of the first calendar quarter, resulting in shares recording substantial losses. Extreme volatility produces indiscriminate falls in share prices. For larger companies this often reflects selling of the index through tracker funds and derivatives. For smaller companies the falls tend to be violent as liquidity is lower. The UK Large Cap index fell over 23% between 21st February and 31st March. The UK Mid Cap and alternative market indexes both fell 30% over that time. At their lows during March they were down over 40%. Moves at this speed have not been seen since October 1987. The rout spread to many markets, not least crude oil, and bonds swung wildly. On 9th March the 10-year gilt yield fell to 0.159%. Imagine investors accepting a total return of 1.6% after ten years! Wild times and wild panic.

In the second quarter there was a strong recovery in many of the Fund’s holdings as the panic subsided and the market started to focus on the potential for recovery. 

During these turbulent times, our approach has been first to focus on the survivability of our holdings. We satisfied ourselves that none of our holdings are likely to fail, in large part because of the quality of the underlying businesses but also because the public markets have facilitated high level access to capital comprising both equity raises and revised lines of credit from the banks.

We then took a view of the future and looked ahead ‘across the valley’ on a two three-year time frame to see where our companies might end up post crisis.

We determined what the sensible price today is for such shares on a post-pandemic basis. The aim here is to buy at an entry price which allows us to benefit from both rising profits and an increase in the price to earnings multiple. The uncertainties of the virus and lockdown make it exceptionally hard to predict the near term. We find it more productive to assess the situation two to three years from now. What should the company be making by then and what rating will this support? Normally it is easier to predict what will happen in three months rather than three years. Thanks to the virus this is not currently the case.

We were selective during the period as we sought to capitalise on the turmoil in the market with four new additions to the Fund, the topping up of 17 existing holdings and the sale of one, which was the subject of a takeover, a theme we are likely to see return over the coming months. In a global context the UK was ‘on sale’ in 2019 and we saw an unusually high number of acquisitions by overseas companies. We expect this to resume when Covid-19 subsides.

During the six-month reporting period there were three major contributors and 10 major detractors.

Commentary

Contributors 

The star performer was racing games developer Codemasters, which rose 22%, contributing +0.95%. The company has been a net beneficiary of the coronavirus pandemic. In the year to 31 March 2020 sales were a robust £76 million (2019: £71.2 million) underpinned by the release of just two new games compared to three the year before. Many important milestones were achieved. The Formula One (F1) contract was extended from 2021 until 2025, Games as a Service (GaaS) was established as a material contributor to the growing back catalogue, there was the continued rapid growth of F1 esports, and, post year-end, the company signed an exclusive licence agreement to develop and publish the FIA World Rally Championship (WRC) videogames and esports tournaments from 2023 through to 2027. The company remains exceptionally well positioned to capitalise on industry trends, supported by net cash of £24.8 million on the balance sheet at the period end. Codemasters also has an increasingly diverse portfolio of franchises performing strongly with powerful tailwinds driving them. Through the strategically important acquisition of its main rival, Slightly Mad Studios (SMS), last November, it has become the leading independent developer and publisher of racing games. In addition, to the leading F1, GRID, DiRT and WRC franchises, SMS brings with it the Project CARS and the Hollywood blockbuster Fast & Furious franchises. Another tailwind is the accelerating trend towards higher margin, digital purchases. In the year to March, digital revenues as a proportion of the total increased rapidly from 59.2% to 67.7%, a positive trend that looks certain to continue. From modest beginnings the company is developing a growing presence on mobile through F1 Mobile Racing with over 19 million downloads, Project CARS, its co-development with NetEase and GRID Autosport. Codemaster’s channel reach has been further extended with the launch of Google’s Stadia streaming service. Another positive industry catalyst is a console refresh by Sony and Microsoft, which will benefit Codemasters fully from 2021. The video games sector globally has an underlying compound annual growth rate of around 8.5%. Management recently commented that ‘the stars have aligned’. We whole-heartedly agree. A core holding.

Liontrust Asset Management rose +20%, contributing +0.66%. During the period, the company marked its near-meteoric climb in assets under management with admission to the FTSE 250 index and in line finals to the end of March. The company bounced back in the first quarter to June after some weakness in March experiencing strong net inflows of £971 million. Post period-end, the company continued its successful strategy of supplementing organic growth through targeted M&A, with the proposed acquisition of the Architas funds from AXA. Once completed later this year, this deal will take Liontrust’s total assets under management to over £25 billion. The deal also significantly bolsters its presence in the multi-asset multi-manager segment and increases its access to financial advisers. We expect Liontrust to leverage its newly acquired assets further through its highly effective sales and marketing platform, further enhancing shareholder returns.   

Hutchison China Meditech (HCM) contributed +0.63%. The company has a portfolio of eight cancer drug candidates currently in clinical studies around the world. Recently, there has been positive newsflow on the drug development front. It has been announced that blockbuster cancer drug, Tagrisso, owned by AstraZeneca, has been confirmed for use as a preventative drug as well as a cure. This represents a big expansion of its market. Clinical trials in which it is used in combination with HCM’s Savolitinib, therefore, represent a potential route to unlocking significant returns for HCM by piggybacking Tagrisso’s extraordinary growth. Positive interim analysis leading to a breakthrough therapy followed by confirmatory Phase III, if successful, could eventually unlock sales of $1-2 billion per annum under a bullish scenario. HCM is also optimistic about the potential for Fruquintinib in the US for the treatment of patients with colorectal cancer. This follows the decision by the Food and Drug Administration (FDA) to allow the drug’s development to be fast-tracked in support of a New Drug Application (NDA). Surufatinib, which is being trialled for the treatment of patients with advanced tumours related to the nervous system, is also being fast-tracked in the US. The market potential is material and the commercial side is being readied now. We believe the market is yet to appreciate the full significance of these developments.

Detractors

IWG, the leading global operator of flexible workspace brands, contributed -1.52%. CEO, Mark Dixon, took full advantage of the sharp fall in the share price in the first calendar quarter buying two tranches of shares at 115.2 pence and 151.2 pence netting him a substantial gain. The company sees more demand for flexible workspace post the coronavirus pandemic. At the end of May, the owner of Regus, therefore, raised around £320 million as a war chest to target distressed assets owned by weaker industry players lacking the scale and balance sheet strength to survive the downturn. IWG has already used its war chest to secure the lease of a Hong Kong based office recently vacated by rival WeWork. In terms of trading, with the future easing of lockdown measures across the world, IWG anticipates a gradual improvement in the second half of the year. IWG has identified cash savings of around £150 million and is confident this gives sufficient headroom in relation to its covenants. If the downturn is more prolonged, it will implement additional savings in 2021. Additional downside protection is provided by having 95% of lease liabilities within special purpose vehicles which have few or no cross guarantees to the quoted parent. This means, as a last resort, IWG can hand back the keys of individual centres and walk away. The pandemic has undoubtedly delayed the programme of franchising the network of over 3,000 serviced offices, but the commercial logic remains powerful.

Restore
contributed -1.19%. As one would expect, its more economically sensitive businesses such as shredding, recycling and office moves, have been adversely impacted by the pandemic, although all of them are said to be continuing to trade. In contrast, storage revenues remain solid and reliable at Records Management, its largest and most profitable business, which effectively represents an annuity stream where clients pay up front for box storage. Where required, swift actions to reduce variable and discretionary costs were implemented with around 45% of staff initially furloughed with some returning in response to growing customer demand. The business remains strongly cash generative in line with expectations and is operating well within its banking covenants. The company has modelled various operating scenarios and is confident that it will remain profitable, albeit lower than reported for 2019.

Marston’s contributed -1.10%. The company’s prospects took a turn for the better following the joint venture with Carlsberg UK to merge their brewing assets. This imaginative scheme not only enables Marston’s to retain a 40% brewing stake in the new company, with its margin-enhancing vertical integration benefits, but also enables it to continue with its debt reduction strategy given the £273 million it is due to receive in cash. Trading-wise, following the easing of the coronavirus lockdown restrictions on 4 July with social distancing reduced to one metre, the company plans to reopen around 85-90% of its pub estate. Given reductions in overheads, break-even should still be possible in the event of 50-70% reductions in sales volume reinforcing its going concern status. 

ITV contributed -1.09%. The company is unable to provide any guidance against the backdrop of a brutal 42% fall in advertising revenue in April. Since mid-March ITV Studios has also had to pause most of its productions globally, including Love Island, because of the restrictions on working practices imposed by Covid-19. On a more positive note, ITV Studios Global Distribution is seeing good demand for library content internationally and there has been good growth for BritBox free trial starts and subscriptions. Interactive revenues are growing well with increased demand for ITV’s competitions. In terms of cash conservation, the company will reduce overhead costs by £60 million in 2020, helped by the furloughing of around 15% of its UK workforce. There will be at least £100m reduction in the programme budget to around £1 billion. ITV has access to around £930 million of liquidity in the form of unrestricted cash and credit facilities. In view of the ongoing uncertainty, however, it has withdrawn the 2019 final dividend. ITV potentially looks cheap under a recovery scenario but there is still underlying structural pressure in linear TV.

Specialist media group Future contributed -1.03%. This share price performance is out of step with trading. Despite the pandemic, towards the end of July, the company confirmed that its strong performance reported at the interims has continued and that trading for the financial year to the end of September 2020 is expected to be towards the top end of market expectations. Audience growth and ecommerce are the two major factors behind this. Online users grew strongly by 26% to 253 million in the first half of the financial year and with the global lockdowns, audience growth then materially accelerated. This resulted in a record-breaking 329 million online users in March, up 66% year-on-year. Organic growth in eCommerce, up 68%, also remains strong with eyeballs continuing to be converted to sales. This is made possible by Future’s market-leading, global platform technology. This enables the business to scale profitably and achieve strong, positive operating gearing as reflected in the operating margin, which increased to 28% at the interims (2019: 21%). Profits need to be turned into cash to validate the business model. With strong interim free cash flows of £40 million (2019: £27.5m), representing 100% of adjusted operating profit, the company also ticks this box. These positive factors offset the inevitable decline in magazine sales in shops and the postponement and cancellation of events. During the quarter, Future completed the acquisition of TI Media and has since confirmed that its integration is progressing in line with expectations. Despite TI’s exposure to magazine sales, the strategic rationale to convert many of its brands and much of its audience to digital remains compelling. Future remains attractive as a growth share on a price earnings ratio of 16.6 and price earnings growth ratio of 0.72 on a 12 month forward rolling basis.   

Marketing specialist Next Fifteen Communications contributed -0.91%. With over half of its revenues coming from the technology sector and with limited exposure to highly affected areas such as travel and hospitality, the company remains relatively insulated from the economic impact of the coronavirus pandemic. When we met up with the company at the end of June, management confirmed that the business was much further ahead than originally envisaged three months previously. All 16 brands and businesses are profitable including two that had to be turned around, and, due to a very strong focus on cash conservation, debt stands at £5 million as opposed to the £20 million originally envisaged around the time of the lockdown. The retention of a strong balance sheet was in part thanks to Government support packages on both sides of the Atlantic (120 staff furloughed in the UK) and to the implementation of cost cutting measures, such that costs are running £10m below budget. The US business has proven more resilient than the UK because it is more B2B focused and the group has proven to be more resilient than the market gives it credit for. It is highly focused on technology and is two thirds B2B. Clients are increasingly thinking through their digital strategies post Covid-19. Consequently, the company has two acquisition targets in its sights, one an innovation consultancy looking at disruptive technological scenarios for clients and the other a web optimisation specialist assisting corporate clients to move towards online first strategies, both of which represent high growth areas. The main note of caution expressed by management is that the pandemic is out of control in the US, and they are, therefore, still cautious about recovery in the second half of the financial year ending January 2021.

STV Group contributed -0.68%. The company was hit in the immediate aftermath of the coronavirus pandemic as advertisers pulled back during the initial lockdown. A fundraising placing 17.99% of the shares, however, has been completed strengthening the balance sheet. This together with the postponement of pension contributions in 2020 and £18 million of identified cost savings, including the furloughing of 40% of staff, leaves STV in a comfortable financial position. Prior to the pandemic, the growth strategy was delivering record TV and online audiences and record rates of digital and regional advertising growth outperforming ITV outside Scotland. We expect the company to kickstart its growth strategy again as and when conditions normalise. The company is lowly valued on a mid-single digit price earnings multiple.

Avation contributed -0.56%. The company’s airline customers have been severely disrupted by Covid-19. It, therefore, instituted a programme of support enabling some of them to defer payment of certain portions of their rent, the cashflow impact of which has been mitigated by adjusting the amortisation profiles of the relevant financings. In addition, to conserve cash, the company reduced administration costs and paused capital expenditure and, as a result, at 31 March 2020 retained a strong cash balance of $131.6 million. Fortunately for Avation, some of its largest customers are in countries where there has been comparatively lower impact from the pandemic. It is now seeing a gradual return to service of certain customers including VietJet, airBaltic, EVA Air and Mandarin Airlines, which represent over 60% of future unearned contracted leasing revenue. Avation remains optimistic about the long-term opportunity for airline travel particularly the turboprop and narrow-body aircraft sectors. Five ATR72-600 aircraft on lease with Virgin Australia which went into administration now look like they will still be required by the new operator.

Arbuthnot Banking (-0.51% contribution) has the essential ingredients to be relatively resilient in its sector. In interims to the end of June, the bank reported surplus capital of £66 million representing 147% of required capital, it has a liquidity surplus more than double the minimum requirement and customer deposits exceed customer loans by around £600 million. Arguably, its assets are relatively low risk, for example, as evidenced by low loan to values. However, the bank acknowledges that the ultimate economic impact of Covid-19 remains unknown. It is not certain how the economy will perform when the government’s support packages are withdrawn. Any resultant impact on credit impairments will therefore not be fully understood until 2021. In view of this. there has been a refocus of the core bank towards residential property lending, which will see the return on capital optimised in the medium term. The immediate challenge facing Arbuthnot, however, is reduced economic activity following the pandemic coupled with historically low interest rates. The decline in the base rate is squeezing margins and at the interim stage cost £2.7 million, as reflected in pre-tax profit falling from £2.9 million to £0.2 million. Looking forward there will be incremental Covid-19 related impairments to factor in as well. Optically, the shares look cheap for a bank with surplus net assets and a strong record.

During the period we also supported certain top-up fundraisings by investee companies, an example being Ten Entertainment (-0.73% contribution). In this case the raise was at 155 pence. Consensus earnings per share is now at 17.2 pence for 2021. So an entry price earnings ratio of nine is already attractive. Estimates earlier in March were 25 pence giving an earnings per share entry price of 6.2, which looks within the company’s grasp in 2022 if the situation has normalised by then. The forecast yield for 2021 is over 6%, supported by a high-teens return on capital. Together these two factors could combine to generate a substantial annualised return. Not bad for a game of skittles. The company will reopen all 39 of its English bowling centres on 1 August, applying strict protocols laid down by the government, including restricted capacity, alternate lanes and additional cleaning.

Outlook

We foresee considerable value to be unlocked in our universe, particularly in the small to mid-cap arena. Some companies are not only well positioned to enjoy a resurgence once the pandemic subsides and business as normal resumes, but many of them will find themselves facing less competition as the weaker, mostly private-sector players fall by the wayside. Businesses which generated consistently good returns on capital before the crisis are likely to perform well afterwards.

Purchases and sales

During the period we sold our position in Amerisur Resources, the subject of a successful takeover bid. We also trimmed our positions in Future and Liontrust Asset Management. We bought Countryside Properties, Dart, Marlowe and Rank and added to positions in AFH Financial, Arrow Global, Breedon, Clinigen, Codemasters, Hutchison China MediTech (ADRs), IWG, Kin & Carta, NCC, Next Fifteen Communications, Prudential, Redcentric, STV, Ten Entertainment, Tesco, SimplyBiz and Trifast.