[Commentary] Slater Income Fund – Interim Report for the six month period ended 31st October 2020

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

Overview and Outlook

The period covered by this report immediately followed the one third collapse in the market seen by mid-March 2020 and the partial rebound achieved by the end of April 2020. The recovery ran out of steam in early June 2020 and the market began to drift gently lower despite the gradual reopening of major economies. Many income stocks were heavily affected both by the earnings impact of the lockdown and the slashing of dividends. Ever-lower interest rates helped growth company shares, boosting the value today of profits many years in the future, but they did little to support companies offering value nearer term. A few days after the period end, we had the news of the Pfizer vaccine which triggered an almost instant 14% rise in share prices. The past is a foreign country, as may be the future.

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.

Growth Companies – Major Contributors and Detractors

Randall & Quilter (R&Q) contributed +1.77% and the shares rose +18%. The business is undergoing a changing of the guard, with a new Chief Executive Officer (CEO) and new Chief Financial Officer (CFO) now established, both of them based in the United States (US). This makes sense as the main driver for growth is the Program Management division which operates mainly in the US. In the first half of the year to June 2020 this increased its premiums by 95%. Ten new programs were added, taking the total to 36. Under the programs, R&Q acts as a bridge between local managing agents and large international reinsurers, charging around 5% of premiums in the process. Profits will build gradually, so the June 2020 first half group profit before tax of £0.6 million, down from £33.1 million, is a poor guide to the direction of travel. Some of the fall was due to a collapse in investment income, to £2.2 million from £16 million, but the bigger factor was last year’s non-cash gain on a bargain purchase of funds in run-off. Consensus earnings per share (EPS) rises 41% in 2021 and 18% in 2022. The shares closed the period at 165p, giving a dividend yield of 7.1% and 8.0% for those years.

Liontrust Asset Management contributed +1.10%, gaining +16%. In deal terms, the highlight of the half year was the £75 million purchase from AXA of Architas, the UK multi-manager. This added £5.6 billion to assets under management (AuM), taking it to £25 billion on 1 July 2020. We decided not to take part in the accompanying £66 million fundraising at 1300p as we already have a substantial holding, though we remain enthusiastic in the medium term. Liontrust has been a great performer and has made smart purchases. The best was the £33 million acquisition of Alliance Trust in December 2016, which brought in £2.3 billion of AuM. This has since swelled to £7.5 billion as investors flock towards sustainability. Fund management is a high-beta investment class and looks set to do well as confidence returns to markets. The consensus EPS rises 20% in the year to March 2021, followed by 27% and 18% in FY22 and FY23. The forward price to earnings (PE) ratio at 31 October 2020 was 18.

Sureserve climbed +31% and contributed +0.82%. A trading statement in October 2020 said September 2020 year end trading was in line with forecasts. The surge in the share price marked a return to stability after years of pain as the company shed its building interests. Consensus earnings forecasts show a 4.5% increase in FY20, followed by 13% and 11.5% in the following two years. The dividend will increase much faster and the yield is expected to reach 3.3% in September 2022.

City of London Investment Group (CLIG) contributed +0.67% with a pleasing +28% gain. The highlight of the period was the £78 million all share merger with Karpus, a US fund manager. The two businesses will be run separately for three years and the Karpus management will together hold 38% of the enlarged business, though only vote up to 24%. CLIG has long term relationships with loyal investors, and so does Karpus. Karpus was acquired at a lower multiple, so earnings in the year to June 2021 are forecast to show a 31% gain. After this a return to single digit growth is more likely. The dividend yield consensus is 7.5% in the year to June 2021.

River and Mercantile (R&M) detracted by -0.56% after falling -25%. Final results in October 2020 showed adjusted earnings down 42%. Performance fees were £1.2 million, down from £12.5 million. R&M earns the bulk of its income from advising pension funds with defined benefit (DB) schemes. This market is declining gently as few DB schemes remain open, particularly in the private sector, but there are still estimated to be 10 million members, down 2 million since 2009. Fluctuating interest rates create demand for R&M’s services, though performance fees are also volatile because of these conditions. The company says it will invest more in its sales and marketing, which may hold back margins. It pays out over 80% of profits via dividends and here the consensus is for a 32% increase in June 2022 and 33% in 2023, giving yields of 7.6% and 10.1% for those years.

Morses Club fell -58% and detracted by -1.05%. Collecting repayments door to door was impossible during the restrictions, forcing the company to vastly accelerate its move online. The CFO departed abruptly and in June 2020 there was further embarrassment when the scandal at Wirecard forced the temporary freezing of some online current accounts provided by Morses. A trading update in September 2020 reported a gradual recovery in lending and collections. A replacement CFO was appointed in October 2020. At the time of writing we are yet to see full year results for the year to 28 February 2020.

Dividend Stalwarts – Major Contributors and Detractors

We debate whether Strix is a stalwart or a growth company. Held on a leash when it was owned by private equity, as a public company it is investing in new products and increasing its range by acquisitions. During the half year it rose +22% and contributed +1.00%. Interim results to June 2020 showed a 21% fall in sales and a 9% fall in EPS. Lockdown was unhelpful but the impact was transitory. The business is moving steadily into the water purification market. In September 2020 it paid €19.6 million up front with a potential €12 million earnout for Laica, an Italian supplier of filters for water jug filters and for coffee machines. The maximum enterprise value to earnings before interest tax depreciation and amortisation ratio on this deal is 10.9. Strix’s forward PE was 14 at 31 October 2020.

Phoenix Group Holdings contributed +0.67%, rising +10%. This is a bigger and more successful competitor to Chesnara. It suffers the same pressures on investment returns but it has more scope for self-help as it harvests the efficiency gains from buying Reassure, a deal which completed in July 2020. It expects to gain £800 million cost and capital synergies from the purchase. These savings will join the further £1.2 billion expected from absorbing Standard Life’s legacy pensions business. These acquirer businesses feed by scrapping duplicated IT platforms and by releasing regulatory capital through creating broader books of assets. They do aspire to generate new savings but, essentially, they are crushers of old corporate bones. Aside from mergers and acquisitions (M&A), Phoenix Group Holdings is also a player in the £25 billion per year bulk purchase annuity (BPA) market. Maturing company pension schemes are gradually selling their books as defined benefit passes into history. BPA generated £1.1 billion cashflow for Phoenix Group Holdings in June 2020 first half, up from £0.5 billion. As with M&A this process will eventually end, but it will generate powerful cashflows in the meantime.

Imperial Brands detracted by -0.77% and the shares fell -27%. Covid-19 has not been the main culprit for its problems. The 44% fall in sales of vaping products, despite heavy marketing, helped cut March 2020 first half EPS by 10.9%. This failure helped cost the previous CEO her job. The current CEO, Stefan Bomhard, is emphatic that future spending in this area will be disciplined. He now uses the term ‘harm reduction’ to describe Imperial’s product strategy. The yield for September 2021 is forecast to be 11.6%.

GlaxoSmithKline fell -22% and detracted by -0.98%. Despite working on a vaccine for Covid-19 with Sanofi, Glaxo’s business has suffered under the virus, particularly its vaccines division. People have paid fewer visits to the doctor and this has impacted vaccinations and prescriptions. The company went through a long fallow period in clinical development, but this has improved recently. Three products were approved in the third quarter of 2020 alone. The impending demerger of the Biopharma and Consumer Health divisions should help, both operationally and in terms of investor interest.

Life assurance acquirer Chesnara detracted by -1.07%. Its shares fell -21%. Reduced investment returns trimmed the Economic Value (EcV) to 403p from 447p during the first half. These compare to the 262p closing price. EcV is a useful indicator in the event of a takeover bid but in the meantime the shares rely on the dividend yield. This stands at 8.4% in 2020 and 8.7% in 2021.

Cyclical Companies – Major Contributors and Detractors

Rio Tinto rose +18% and contributed +0.70%. The shares recovered briskly from the market panic within two months and then pushed higher as China emerged from its early lockdown. This recovery was despite the uproar over the dynamiting of caves in Australia judged sacred to local aborigines. Rio survived but CEO J-S Jacques became a casualty and will stand down on 31 March 2021. Brazil’s dam collapse was a fillip to Rio, sharply reducing output by Vale, its big Brazilian competitor. Brazilian output will recover, and we note that consensus forecasts for 2022 see a 20% fall in EPS. The yield this year is 7.6%.

Anglo Pacific Group had a very disappointing half year, falling -34% and detracting by -0.52%. The lower price of coal was a clear negative in the first half of the financial year (H1), but royalties were also impacted by lower output at the Kestrel mine in Australia. It supplies metallurgical coal to China and should see a recovery next year (2021). Kestrel royalties fell 47% in H1 and only contributed 63% of income. The dividend from the Labrador Iron Ore company also fell 33%, reflecting lower output. Anglo responded by announcing a £5 million buyback. Meantime its supporters want to see more evidence of it broadening its portfolio of royalties to reduce the exposure to steelmaking.

BP detracted by -0.76% and Royal Dutch Shell (RDS) by -1.07%. BP fell by -37% and RDS by -28%. Both now pepper their announcements with descriptions of their march towards sustainability. Some investors are simply abandoning the sector, which is understandable as BP in particular seems to want to join them. We do expect oil and gas consumption to fall over coming years, but in the near term the global consumption, Covid-19 aside, for both is actually still rising. This is more marked in the case of natural gas. Weaning the world off using coal for power generation is the most immediate task. Investment in the oil and gas sector has slumped and this suggests a sharp rise in prices is likely in the medium term as capacity falls. RDS’ EPS is expected to nearly double in 2021 and rise a further 58% in 2022, giving a PE of 6.2. For BP the PE is 7.7 in 2022.

Additions and Disposals

During the six months we bought Fonix Mobile

We added to Redcentric and STV Group and received shares from Duke Royalty (scrip dividend) and Randall & Quilter (bonus issue).

We sold Arena Events Group, Barclays, Centaur Media, Close Brothers Group, Forterra, LafargeHolcim, Lloyds Banking, Prudential and RBG Holdings.

We reduced our holdings in BP, Brewin Dolphin, Chesnara, GlaxoSmithKline, ITV, Legal & General, Liontrust Asset Management, Lok’n Store, Marston’s, Mears, National Grid, Ocean Wilson Holdings, Phoenix Group Holdings, Randall & Quilter, Rio Tinto, Royal Dutch Shell, Strix, Supermarket Income REIT and Tesco. The scrip shares received from Duke Royalty were also sold in the period.

Outlook

At the time of writing the outlook for Covid-19 is looking more hopeful than at any time since the epidemic was unleashed. Investment is where short term hopes and fears meet long term realities. In the end the realities win. Our companies have been reporting better and better trading news in recent months and we are encouraged by a similar trend towards cash dividends being reinstated. We therefore expect steadier and better returns going forward.