[Commentary] Slater Income Fund – Annual Report for the year to 30th April 2019

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For a PDF of the Full Report, please click here.

Overview and Outlook

In footballing parlance, the performance of the Slater Income Fund over the period was a ‘game of two halves’.

First, global financial markets went into a tailspin during the final calendar quarter of 2018. Growing panic was triggered when the US Federal Reserve (the Fed) raised rates on 10 October 2018, which was dubbed ‘crazy’ by President Trump. Investors concluded the central bank was steering by its model rather than by actual conditions.

Then, on 19 December, the Fed changed tack lowering its 2019 projection to two increases for its benchmark funds, which took the target range rate to 2.25% to 2.5%. This triggered a sharp change in investor sentiment and acted as a catalyst for a strong rebound in stockmarkets.

This reversal in fortunes is usefully illustrated by the performance of the Slater Income Fund P Income unit class over one year to 30th April 2019 (loss of -2.62%), against its year to date performance to 30th April 2019 (gain of +13.27%).

Objective

The investment objective of the Fund is to produce an attractive and increasing level of income whilst additionally seeking long term capital growth through investing predominantly in shares of UK listed equities.

We seek to achieve a consistent performance by broadly dividing the Fund into three complementary categories – growth companies with attractive yields; dividend stalwarts with earnings pointing upwards; and high yielders with more cyclical upside. In all three categories we are looking to invest across the market capitalisation spectrum.

Major contributors and detractors (over 0.20%)

Growth Companies

Contributors

Insurance specialist Randall & Quilter has been a strong performer over the year contributing +0.55%. At the end of April the company confirmed profit growth in 2018 had benefitted from a strong contribution from previous run-off transactions within its legacy business. The surge in the price last autumn, however, was partly due to its $80.5 million cash purchase of Global US Holdings Inc, a reinsurance company which went into run-off in 2002. Last December Randall & Quilter said it would not be able to complete the deal before year end, moving an expected profit from 2018 to 2019. This year’s forecast of bumper profits of £42.2 million remains sensitive to the gains on the Global transaction. Nevertheless, we have confidence in the long-term track record of top management and like the progressive policy of shareholder distribution.

Liontrust Asset Management contributed +0.27%. During the first calendar quarter of 2019 assets under management increased by 13% to £12.7 billion and were 21% higher year on year. Net inflows were strong. A net £581 million flowed in during the period and £1.8 billion for the twelve months to March. This was achieved against a challenging backdrop with negative retail fund flows across the UK industry in six out of the seven months up to and including February 2019. The company puts its success down to the broader breadth of its asset classes and approaches to investment that it now offers. The company remains confident for the new financial year. Liontrust sports a decent prospective yield of 3.8% to boot.

Hollywood Bowl (+0.26% contribution) managed to chalk up impressive like-for-like sales growth of 4.4% in the half year to March. The business grinds out a return on equity in excess of 20% each year and shows no sign of stopping. Over time a lower growth rate seems likely because Hollywood Bowl typically only adds two new centres each year, which it has already achieved in the first half. Even so, the consensus forecast for the year to September 2019 still sees 8% earnings per share growth. In addition, it remains on track to complete between seven and nine refurbishments. In April the company confirmed that it is trading in line with expectations and that it has a strong pipeline of new centres secured to the end of financial year 2022.

Strix Group (+0.25% contribution) posted strong 2018 results with profit in line. The global kettle market grew at 7% and the company increased its own volumes by 7.9% thereby maintaining its 38% world-leading market share. This was achieved without sacrificing margin as evidenced by the gross margin increasing by 0.8% to 41.5%. During the period, it sold 2.7 million units of its newly developed low end, low cost kettle control designed to capture a greater share of undeveloped markets. Strix is now very much on the front foot and has developed a range of exciting new products for launch this year and next. It has also materially increased its market share for its Aqua Optima range of consumer water filter devices to 25% in the UK, which is starting to have a meaningful financial impact. Geo-political events aside, the company looks well positioned for growth. The company has an above average prospective yield of 5.1%.

STV Group (+0.20% contribution) issued an upbeat first quarter update, in which it confirmed that it is trading in-line with expectations. Most notably, the company highlighted that total advertising revenue across national, regional and digital channels is expected to be up 1% to 2%. Within this, national advertising revenue is only expected to be down 1% to 2% compared with a previously guided 5% drop. Regional advertising continues to perform strongly, up 20% to 25%, driven by the on-going success of the STV Growth Fund which has now partnered with more than 130 Scottish advertisers, over half of whom are new to TV. Digital revenues are also expected to be up 15% to 20% reflecting continued strong growth from the STV Player, fuelled by hit dramas like Manhunt, Cheat and The Bay. The Production business continues to perform in line with revenues secured by the end of the first quarter equivalent to over 60% of the total achieved in 2018.

Detractors

Following a profit warning in June 2018 we started reducing, and subsequently sold, our holding in XLMedia (-0.72% contribution) to lock in material profits compared with its original acquisition price.

McColl’s, the convenience store chain, contributed -0.72%. A trading update in early December 2018 warned of zero like for like sales growth and brought a further downgrade to forecasts. Convenience was supposed to offer a refuge from the internet but McColl’s fell victim to discounting by first the German food retailers and then the mainstream supermarkets. We sold our holding.

Amino Technologies (-0.57% contribution) shocked investors in October 2018, warning of ‘an intensification of external macroeconomic headwinds.’ Coming only shortly after a confident outlook at the half year, this was particularly disconcerting. The culprit was confusion over how certain products should be treated under new US tariff arrangements introduced by the Trump administration. Amino is seeking, over time, to transition away from selling commoditised hardware to a higher margin software and services model. Preliminary results in February were in line with the company’s December update, reiterating the company’s strong balance sheet with net cash of over $20 million, strong cash generation and a capable management team.

After disappointing interim results and subsequent trading update we sold our position in Hostelworld (-0.36% contribution).

RPS Group contributed -0.33% over the period. However, this fails to capture the strong rebound in the share in the first four months of 2019. The company not only provides consultancy on civil engineering projects and environmental schemes but also hires out geologists for the energy sector. The Energy division still has plenty of scope for recovery. In 2018 it contributed £9 million to group profits. However, this is still way below the £36 million generated in 2013. The price of Brent crude is comfortably above the break-even point for most oil companies, underpinning the economic viability of that sector. The valuation, therefore, remains attractive given the recovery potential in energy. In the meantime, the stock generates an above average prospective yield of 5.2%.

Sureserve Group (-0.31% contribution) had a transformational year and is now better-positioned for more predictable growth having streamlined its operations to focus on its industry-leading Building Compliance and Energy Services businesses. These are profitable and significantly cash generative and, when firing on all cylinders, should be capable of delivering a net 5% margin. The company now has much better visibility of non-volatile essential services income, underpinned by a £385 million order book and a growing national footprint. Operational highlights included the award of a £55 million contract under the Welsh Government’s ‘Warm Homes’ programme.

Other detractors included Photo-Me International (-0.27% contribution), Maintel Holdings (-0.26% contribution), NAHL Group (-0.23% contribution), Plus500 (-0.24% contribution) and Telford Homes (-0.23% contribution).

Stalwart companies

Contributors

The star performer amongst the stalwarts was Diversified Gas & Oil which contributed +1.20%. Towards the period end, the company undertook a further transformational acquisition, opening up a major shale opportunity by agreeing to buy a package of mature shale wells in Pennsylvania and West Virginia for $400 million. The deal increases the company’s production by a material 30% and increases the run-rate of earnings before interest, depreciation and amortisation by 39%. After allowing for equity dilution, annual free cash flow per share is forecast to rise by around 20%, increasing the likelihood of a further sizable increase in the dividend. The rapidly rising prospective dividend yield (now just under 10%) is one of the main drivers behind the strong share price performance. Because it is quoted on the public markets, the company is uniquely positioned in its role as industry consolidator with greater access to funds and deeper pockets than competitors.

Mining giant Rio Tinto contributed +0.56%. One of the main reasons for the strong rise in the share was the strength in the price of iron ore, which, during the first quarter of 2019, rose almost 28%. The market tightened initially following the Brumadinho dam disaster which could result in Vale’s iron ore sales falling by as much as 75 million metric tons this year. This event was followed by tropical cyclones which damaged Rio’s port facilities and, as a consequence, Rio’s iron ore production fell and its 2019 guidance has now been reduced. The operational performance for Rio’s other products (Bauxite, aluminium, copper and titanium oxide) in the calendar first quarter, however, was robust and generally higher than in 2018. The company remains disciplined in its allocation of capital with a view to maximising shareholder returns. The stock generates an above average prospective yield of 5.7%.

Legal & General contributed +0.20%. The stock generates an above average yield of 6.5%. This is underpinned by strong fundamentals. Excluding a £433 million positive mortality release, which is essentially a windfall gain on reduced life expectancy, operating profit was up 10% in 2018, earnings per share grew 7% and book value increased 13%, evidencing balance sheet strength. The company remains a consistent performer having delivered eight consecutive years of compound annual profit growth of over 10% and it has significant scale giving it a strong competitive position. In 2018 it became the UK’s first £1 trillion investment manager and is now starting to build scale globally with international assets up 13% to £258 billion. Investors fret about Legal & General’s exposure to interest rates, but its solvency ratios look very healthy. Current trading is strong and management expect the momentum to continue during 2019.

Detractors

Royal Mail contributed -0.70% and was sold. The long-awaited deal with the Communication Workers Union seems to have delivered the expected cost increases but not the productivity gains to fund them.

Barclays contributed -0.41%. The share has underperformed a number of its FTSE 100 quoted peers over the period. Therein lies the opportunity. Shareholder activism is putting pressure on the board to scale back its poorly performing investment banking division. First quarter results were lacklustre with a 3% revenue miss, offset by costs and impairments giving further ammunition to the activists. Management acknowledges that costs must be reduced further if revenues do not pick up. Value clearly remains to be unlocked with the shares trading at a heavy discount to tangible net asset value and offering an attractive, well-covered prospective yield of 4.9%. As an incumbent, the company has a very low cost of capital and given its strong domestic franchise will be a major beneficiary of any interest rate rise.

Cyclical companies

Detractors

Construction business Kier (-0.61% contribution) was sold before and after the company announced its £264 million rights issue, which was left with the underwriters. This was despite issuing the new shares at a deep discount. Repairing roads should be a very steady business. Kier diversified into speculative housebuilding and other cash-hungry businesses, and in doing so lost the confidence of its creditors.

Additions and disposals

During the year the Fund spent £26.46 million on acquisitions and received £22.99 million in sale proceeds.

We bought new positions in Anglo Pacific, Arrow Global, Barclays, Duke Royalty, Gordon Dadds, Greencoat UK Wind, H&T Group, JPJ, MJ Gleeson, Morses Club, Real Estate Investors and Rosenblatt. We added to positions in Arena Events, Charles Taylor, Diversified Gas & Oil, ITV, LafargeHolcim, Lloyds, Randall & Quilter, Royal Dutch Shell and Sureserve.

We sold positions in Amino Technologies, Assura, Eurocell, Gattaca, Hansard Global, Hostelworld, John Laing Environmental Assets, Kier, Land Securities, McColl’s Retail, NAHL, Photo-Me, Royal Mail and XLMedia. Plus500 was bought and sold during the period. We reduced our holdings in City of London Investment Group, Hollywood Bowl, Lok’nStore, Regional REIT and Rio Tinto.

Conclusion

2018 was a testing year, especially during the fourth quarter when many share prices made new lows. Whilst such conditions were extremely unpleasant for owners of equities, we are confident that as in 2008-9, the pain was the price we had to pay for very strong returns in the following years. The Fund has got off to a strong start in 2019 with a double digit year to date gain. We believe many companies are still mispriced by the market and in some cases the mispricing is extreme. Single digit price earnings ratios remain common. We therefore see strong upside potential in the Fund.

Slater Investments Limited.
June 2019