Lowland Investment Company — One of the purest UK domestic plays in the sector

Investors continue to be preoccupied by the major themes of the war in Ukraine, rising inflation, the associated potential path for interest rates and the Chinese government’s COVID-19 policies, which are all causing slowing global economic growth. Over the year to date, these concerns have seen global markets sell off by around 6%. The broad UK equity index has performed relatively well in comparison, producing a modestly positive return. This can be attributable to the valuation support offered by UK equities (according to Janus Henderson Investors, UK equities are trading at the widest discount to global equities in 25 years) relative to other regions and the mix of industries. The broad UK equity market has a weighting of 21.9% in financials, which is expected to benefit from rising interest rates, 20.0% in basic materials and energy, which have been lifted by strong commodity prices, and only 1.3% in technology.

Global growth will likely slow with the current headwinds and the drivers of this trend are not short lived or easily overcome. Higher food, energy and input prices are a substantial tax on consumers and corporates alike, so it will become even more crucial to be able to identify those companies with defendable barriers to entry, strong reoccurring cash flows, solid balance sheets and talented company management able to navigate this landscape. LWI is well placed to achieve this. The wider equity income team at Janus Henderson Investors are highly resourced and have some of the industry’s most experienced income investors; Director of UK Investment Trusts and portfolio manager James Henderson has been at the helm since 1990 and has worked with portfolio manager Laura Foll since 2009. The combination of their experience and collegiate approach is likely to be even more important in the coming years.

For the half year ended March 2022 the portfolio returned -0.7% on an NAV basis (3.5% in price terms), compared to 4.7% for the index and 3.1% for peers. The fund’s earnings per share were 1.72p over this period (H121: 1.28p), but this still has some way to go to catch up with the pre-pandemic H119 figure of 2.22p.

Looking at a slightly longer-term perspective, performance over the 12 months to the end of May 2022 was -0.5% in NAV terms and -7.2% in price versus the 8.5% for the broader UK market. Over this period, higher yielding stocks in the UK performed well versus those that were more growth oriented. As with the interim period, the largest UK listed companies returned 12.4% whereas small and medium-sized companies returned -6.4% and -8.8% respectively. The AIM index was even weaker, returning -21.5% over this period. Within this context the fund’s NAV performance was relatively credible, given the high exposure to AIM, mid and small caps.

As shown in Exhibit 4, the portfolio has a bias to smaller and medium-sized companies (normally weightings to the largest 100 UK companies do not account for more than 50% of LWI’s portfolio) when compared with the benchmark; this was a source of much of the underperformance during H122.

Conversely the bias was a major driver of the very strong outperformance in 2021 (Exhibit 5). Smaller companies can often be volatile in times of macro uncertainty and events such as the war in Ukraine, rising inflation and general “risk off” environments can hurt the share price performance of these companies. Their performance can also be seen as a barometer for the sentiment surrounding UK domestic earnings and growth and indeed LWI is more exposed to UK domestic earnings then peers according to work done by Morningstar (Exhibit 1). Whilst the weighting to the largest companies has been towards the upper end of the typical range (Exhibit 4) and has increased from 35% since April 2017, the managers acknowledge that with the benefit of hindsight they could have been raised a little more to add to the defensiveness of the portfolio.

Unsurprisingly given the robustness of the largest UK companies and rising energy and basic material prices, the three best-performing portfolio holdings over the interim H122 period were Anglo American, Shell and North Sea oil and gas producer Serica Energy. The three largest detractors to performance at the stock level were Studio Retail, Reach and K3 Capital. Studio Retail was a victim of supply chain issues, whereas Reach and K3 previously performed well but saw share price weakness on concerns regarding future economic growth.

Transactions were modest through the period, with net sales of £9m. Bellway was sold in January 2022 as the managers had concerns about the affordability of housing in England in a rising interest-rate environment. Scotland has not seen the same magnitude of house price appreciation, so a new position was added in Springfield Properties. New holdings were also added in H221 via Kingfisher and Reckitt Benckiser that, although had both benefited from lockdown trends, have also been making self-help improvements in their respective underlying businesses. More recently banks have appeared more attractive to the managers. Balance sheets are well capitalised and the managers have been adding to Barclays after initiating a new position in Q420. Barclays pays a dividend of 4.8% and trades on price to book of 0.4x. Rising rates provide a tailwind for the banking sector and the fund owns holdings in HSBC, Lloyds, NatWest and Standard Chartered. This is a rare example of investments being identified from a top-down perspective, rather than the overwhelming bottom-up process long eschewed here.

Cranswick was added in April 2022 and is the pre-eminent UK pork supplier to retailers. It also sells under its own brands and has a foothold in the poultry market. Although input cost pressures are undoubtedly an issue, the strength and durability of its brands and relationships with the major supermarkets puts it in a strong position to pass through costs. The stock was weak over the previous 12 months, offering the manager an attractive entry point on an EV/EBITDA of c 8x. There are other food producers in the portfolio, such as Finsbury Food Group and Devro. Pension consultant XPS Pension Group was another addition in April 2022. XPS Pension Groups gaining market share from larger incumbents via its nimble and bespoke solutions and the managers believe it is well placed to grow earnings while paying an above average dividend. Further capital has also been added to insurer Direct Line and Epwin Group, which provides door and window frames for builders merchants and housebuilders.

The funds for these purchases have come from selling RELX, reducing Randal and Quilter and taking profits from the overweight utilities positions that have performed well in the recent market volatility. Taking a step back, the direction of travel is to reduce the more defensive, earnings transparent, more fully priced elements of the portfolio such as utilities and reinvest the proceeds into more cyclical areas such as banks, housing-related business and food producers, where short-term investor pessimism prevails but the fundamentals are robust. The managers believe the portfolio is well positioned, but for the value to be fully reflected it requires a moderately less volatile economic and geopolitical back drop.

The portfolio has seen external validation of its value with holdings in RSA and St Modwen bought by trade buyers and private equity respectively in the last 18 months, whereas Elementis and Senior have rebuffed approaches from US peers and private equity. Given the value on offer in the portfolio it would not be surprising to see more M&A activity, although this is not something Henderson and Foll particularly welcome as they prefer to benefit from the long-term operational outperformance and share price rerating rather than the immediate benefit to the portfolio from a takeover.

Since the COVID-19 crisis began in early 2020, the board has been understandably especially prudent in decisions about dividends. Despite the volatile nature of corporate profitability especially in the early phase of the crisis, LWI modestly increased its own payouts to investors. Henderson and Foll are encouraged to see the portfolio’s dividend receipts are recovering and are at the top end of their expectations. In 2021 there were special dividends from resource companies as commodity process soared, in 2022 special dividends have been more broad based via Sabre, Headlam, DFS. In addition, FBD Holdings and Irish Continental have returned to paying dividends for the first time since the COVID crisis began in early 2020. Low market valuations have also prompted company management to buy back shares with portfolio companies Direct Line, Ibstock, DFS and Headlam being notable examples.

Although the managers do not rule out any sector or industry, their emphasis on value, dividends and their growth has long funnelled their focus towards certain areas and away from others. This process has given the portfolio a bias to cyclicals and away from defensive industries. In this case cyclicals are defined as basic materials, consumer cyclicals, financial services and real estate. Defensives are consumer defensives, healthcare and utilities. LWI is well known for its industrials exposure, which is high when compared with the benchmark (Exhibit 8).

Within cyclicals, financials make up the bulk of the weighting with a range of holdings via subsectors such as banks, insurers, asset managers and capital markets. The most prominent of these are Direct Line, Aviva and Phoenix. As a cohort these trade on attractive P/E and P/B valuations with a solid track record of paying dividends (Exhibit 9). Financials are often supported in a rising rate environment and are in a better capital position than previous cycles. Within the very diverse industrials sector there are holdings in industrial transportation via Redde Northgate, aerospace and defence via BAE Systems and electronic equipment producer Ilika. There are some larger individual positions in defensive industries such as healthcare and utilities via names such as GlaxoSmithKline, AstraZeneca, Severn Trent and National Grid. These established dividend-paying large caps balance some of the more growth-oriented, more volatile mid and small caps and give the portfolio some balance and stability.

A crucial element of the process looks for robust, well-capitalised businesses able and willing to ride out periods of weaker demand. As Exhibit 9 illustrates, the aggregate level of debt across the portfolio is below that of peers and the wider market. This should give the portfolio an element of resilience in economic downturns, allowing continued investment and for companies to pay dividends.

Ongoing macroeconomic headwinds show few signs of abating and UK equities remain out of favour with investors. Henderson and Foll contrast this negative picture with their own discussions with corporate management who have tended to be more upbeat on their prospects. UK corporates have been buffered by successive crises including Brexit, COVID-19 and the war in Ukraine and may well yet face a modestly recessionary environment. Despite all of these concerns, the managers believe the valuation support and low debt levels mean the portfolio is well positioned to survive the current turbulence, reward investors with their patience via higher and growing dividends and emerge from this market volatility well placed to deliver good capital returns.