[Commentary] Slater Income Fund – Interim Report for the six months to 31st October 2019

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

Objective

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

Fund Performance

During the half year the Slater Income Fund returned -1.43%, which compared to the IA OE UK Equity Income benchmark return of -0.22%. At 31st October the Fund had 2.58% of the portfolio in cash.

Market commentary

The markets usually make weaker headway in the six months to 31st October each year. This year followed that pattern. Fears of a slowing domestic economy have hurt sentiment, with the Brexit issue droning away in the background. There has clearly been a weakening in construction with many decisions being delayed. However, it is hard to find cases of full-blown recession when interest rates are low and staying low. Three of our investment received takeover bids, two from overseas investors. This reflected the weakness of sterling which helped the foreign-earning large caps outperform domestically focused companies.

To recap on the Fund’s strategy, 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

Safecharge International accepted an $889 million cash bid from Nuvei, a private Canadian company. The shares rose +40% in the period and contributed +0.43%. At our last meeting with the company the Chief Executive Officer (CEO) made it clear that he either needed to acquire heavily or be acquired. The payment processing industry is one of scale and staying small is not an option. Safecharge was a very pleasing investment for the Fund.

Liontrust Asset Management contributed +0.31%, rising +21%. March 2019 year end results, reported in July 2019, showed profits up +10% and assets under management (AUM) of £14.1 billion, up +11% during the second quarter of 2019. This had risen to £14.6 billion by the end of September 2019. Liontrust also bought Neptune Investment Management for £40 million, which added a further £2.7 billion of AUM, taking the total to £17.4 billion. Fund managers are inevitably highly correlated with the overall market, but we remain very pleased with the company’s record of acquiring teams which cover fashionable areas.

Marston’s has been a difficult share for some time but seems to be coming good. It contributed +0.28% after rising +22%. The rise was partly a reaction to the £2.7 billion takeover in August 2019 of Greene King at a 51% premium. The shares had already been recovering based on better trading in the Spring of 2019. This progress was dented a little in October 2019 when it reported weaker food sales set against rising labour costs. A trading statement predicted underlying profit before tax of £101 million for the year to September 2019, and forecast a similar result in the following year. The company’s focus is firmly on reducing debt, shedding smaller wet-led pubs. In November 2019 it sold 137 pubs for £45 million, around 15 times earnings. Marston’s combined market value and debt is currently around 14 times its taxed operating profits, meaning the disposal was not dilutive.

Charles Taylor (+0.23% contribution), the insurance services group, received a private equity backed management buyout bid at 315p. We had been unhappy with the share price performance and engaged with the chairman to find a buyer for the company. The shares rose +35% in the half year to 318.5p. We await developments. Although this has been a profitable investment, we are not overly pleased with this outcome, especially with the Executive Directors so conflicted. The shares have laboured under the extreme complexity of the financial statements, made much worse by the presence of a small life assurance business on the balance sheet. Underlying cashflows have been hard to analyse as a result. We suspect Charles Taylor is about to see an acceleration of growth from its insurance technology business. The take-out multiple is only 12.4 times earnings and the dividend yield is 3.9%.

Randall & Quilter (+0.20% contribution) reported continuing half year pre-tax profits of £33.1 million, more than three times the level of the previous year. The shares rose +7%. The Legacy business continues to make excellent progress with five acquisitions and three reinsurances completed in the period. The Program Management Business is growing strongly and there is good visibility of future commission earnings. The company expects $1 billion of premium income to be put through this business in 2020, with a step change in profitability in due course taking into account a time lag of one to two years between signing up new business and revenue generation. The key issue is whether Randall & Quilter will be able to maintain the 5% commission it charges on cover where it arranges reinsurance. At a meeting with the company we were told that it may start managing reinsurance with backing from pension funds. This would make it easier to protect that attractive margin. Legacy business is more difficult to predict as the size and timing of deals can have a significant impact on profit in any given period. However, the pipeline looks strong with two significant legacy acquisitions completed.

Major detractors

Arena Events Group delivered a -0.23% contribution and a -52% share price fall. It has had a torrid 2019 after two profit warnings and in the half year to June 2019 reported an operating loss. The company, however, looks like it is on the turn. Management has been upgraded with the appointment of a new boss for its troubled United Kingdom division, and a new group Chief Finance Officer. Trading prospects also appear to be on the up. Post period end, the company secured two multi-million pound contracts for the Riyadh Festival, as well as a contract for the World Heavy Weight Boxing Championships. The company also sees a significant on-going opportunity to grow its presence in Saudi Arabia. Arena offers an above average prospective yield of 7.4% while investors wait.

RPS fell -27% and contributed -0.26%. Its purchase of an Australian planning consultancy was poorly timed as the business immediately suffered from delays in decision-making by state governments. This led to a warning. The company reported a -40% fall in interim profits but we left our meeting with management feeling more positive. This was borne out by a trading statement in October 2019, which reported a recovery in Australia.

Centaur Media detracted by -0.27% after falling -38%. The promised sale of The Lawyer failed to be agreed because bids were too low. Chief Executive Andria Vidler was replaced by CFO Swag Mukerji. Her disposal programme has left the company with an overhead it can no longer support. The new CEO has promised to slash costs but investors are understandably sceptical.

Stalwart Companies

Major contributor

GlaxoSmithKline (GSK) contributed +0.20% and rose +12%. It has been successfully rebuilding its development pipeline. Most recently at the end of September 2019, it announced that in a late-stage study, Zejula, which it acquired as part of its $5.1 billion purchase of Tesaro, was shown to cut the risk of disease progression or death by 38% across the full spectrum of first-line ovarian cancer patients. These results appear to validate the strategic acquisition of Tesaro last December 2018, given that the latest data demonstrates that Zejula is best-in-class with the potential to capture a larger share of the patient population, almost two times that of second line treatments. This latest trial result on the drug development side is timely given that the company is targeting a break-up of the group after it agreed to spin off its consumer healthcare business in a £10 billion joint venture with its United States rival, Pfizer. GSK is planning to demerge and float the consumer health business, splitting the group into two distinct companies: one focused on the consumer and the other on drug development and vaccines. This promises to unlock additional value for shareholders over the next three years or so.

Major detractors

Imperial Brands fell -31% and detracted by -0.36%. The company reported March 2019 interims showing a 1.1% rise in adjusted earnings per share. This was followed in September 2019 with a warning that sales of its Blu range of vaping products had failed to meet expectations despite a heavy marketing investment. Two weeks later Chief Executive Alison Cooper announced she would be leaving. Blu has trailed far behind Juul in the United States but faces the same gathering regulatory onslaught. Multiple deaths from users of vaping devices are a further concern even though they may result from using non-standard materials. Imperial Brands remains a heavily profitable company but the next CEO seems very likely to rebase the dividend.

Diversified Gas & Oil was sold during the period. It contributed -0.40%. Only recently a market favourite, it was attacked for having a policy on well cost abandonment which was too far distant from others in the sector. This is a complicated issue, both in terms of engineering and accounting. The company takes the view that it will probably never have to bear the cost of plugging many of its 6,000 gas wells. As a result, it has used a high discount rate of 8% to reduce the present cost of abandonment and it also assumed very long production lives. By contrast, BP uses a 3% discount rate. It is fair to say that initially we shared Diversified’s view on this issue. But as environmental concerns increase, so does the risk that a future United States administration will force companies to transfer hard cash into abandonment funds, much as most businesses now do for pension schemes. It is also increasingly imprudent to use a high discount rate on the plugging costs, as there is less and less guarantee that pumping gas will be a profitable activity seven, eight or nine decades from now.

Chesnara fell -29% and contributed -0.51%. It has lagged its peers recently in terms of share price performance. The main message from management is that there has been no change in the business, except an absence of deals which was not due to a lack of targets, as there is still an appetite to offload books, but due to price. The ReAssure acquisition of Quilter and similar transactions in Holland have established very high expectations from sellers as they were at a 20% premium to funds. This is a major contrast to historic discounted rates for deals. We believe that the company is right to be disciplined and not overpay. Meanwhile, the company offers a highly attractive above average prospective yield of 8%.

Cyclical companies

Major contributor

Cement giant LafargeHolcim contributed +0.20% despite its shares falling -3% in Swiss Francs. This was thanks to its dividend, yielding 4% per year, plus the 4% rise of the Franc versus Sterling. We can see signs of construction slowing in various markets, particularly in the United Kingdom, but Lafarge has a global footprint. It has reported mild weakness in Continental Europe but, along with other industrials, the share price has been resilient this year. Ultra-low interest rates usually outweigh near term gloom.

Major detractor

Ocean Wilson fell -27% and detracted by -0.39%. This disappointing performance followed the announcement in July 2019 that it had abandoned plans to sell its Brazilian ports business, Wilsons Sons. This decision followed statements by Brazil’s new president that he opposed further asset sales to China. This caused potential buyers to pause their interest until there is more clarity. Lower iron ore exports have impacted export volumes from the ports and competition between towage providers remains fierce. The medium-term picture is brighter as the new government’s pro-business policies take effect. There will also be more activity in the offshore oil sector, which should reduce the oversupply of towage services.

Acquisitions and disposals

During the six months we bought Prudential, Sirius Real Estate and Tesco. We added to Arrow Global, Greencoat UK Wind, H&T, MJ Gleeson and Morses Club. We sold Diversified Gas & Oil, Mortgage Advice Bureau, Safecharge International (takeover) and Telford Homes (takeover). We reduced Centaur Media, Lok’n Store, Phoenix and Rio Tinto. Via demerger from Prudential, we gained a shareholding in M&G.

Outlook

The United Kingdom equity income sector has been deeply out of favour since 2016 with valuations under pressure from concerns about Brexit and threat of a Corbyn government. In this environment, small and midcap income stocks have borne the brunt of adverse investor sentiment. Both threats could be resolved by the forthcoming general election in December 2019. An end to this uncertainty will release animal spirits and we would expect our Fund to perform strongly in such circumstances given the attractive level of valuations today.