UK small and mid-cap (SMID) equities and domestically focused areas of the market performed relatively well over the quarter as a whole as their valuations began to reflect the more encouraging macro-economic data seen over the summer. However, renewed fears around a disorderly Brexit and the implications of a second wave in Covid-19 infections weighed on sentiment towards the end of the period. There was renewed overseas M&A interest in UK quoted mid cap companies at the period end.
Certain secular trends, for example online retail and more frequent working from home, have accelerated as a result of Covid-19, which was reflected in the fund’s outperformance this quarter. Our top individual contributor, petcare specialist Pets at Home, reported resilient trading since the start of its new financial year, which coincided with the implementation of lockdown across the UK. It was helped by the surge in demand for pets following the shift to working from home, while essential retailer status meant stores could remain open during the crisis. Homewares retailer Dunelm confirmed the degree to which its new digital platform outperformed in April, May and June when online sales surged, more than doubling year-on-year over these three months combined. Meanwhile, IT infrastructure specialist Computacenter converted the increase in demand for IT equipment due to more home working into very resilient results. The company reported H1 earnings substantially ahead of H1 2019 and reported a better-than-expected start to H2 following a strong July and August, with full-year results for 2020 expected to surpass a record-breaking 2019. Additionally, Dunelm and hobby and crafting business Games Workshop have benefited from the release of pent-up demand after their physical outlets were able to reopen for business.
All of these companies we feel have good long-term growth prospects – Games confirmed a fourth year of record constant currency sales, profits and cash generation, despite Covid-19 impacting operations for the final two months of its financial year. We see good ongoing potential as the company selectively licences its intellectual property to create many new products across a wide range of new media towards becoming a truly global franchise. Meanwhile, Pets at Home and Dunelm are exemplars of UK retailers giving customers what they want, coping well with the shift online and investing to improve the customer experience (both online and in-store) and so have been better able to weather the crisis. We were also encouraged to see a further improvement in the performance of Pets’ recently restructured veterinary operations following the introduction of new fee arrangements. Fee income is set to increase this financial year as the adjustment improves the sustainability of the group’s owner-manager model, where practices are jointly owned with the vets who operate out of Pets superstores. Language translation software specialist SDL performed well following a recommended bid from patent translation, filing and intellectual property services business RWS.
On the negative side not owning security company G4S detracted following a formal 190p offer from industry peer Garda World. Exploration and production business Premier Oil performed poorly as crude oil prices took another leg down and following a public battle with its creditors over a proposed acquisition. The weak oil price also negatively impacted sentiment towards marine service specialist James Fisher & Sons.
We increased our position in internationally diversified thermal processing specialist Bodycote and commercial real estate business CLS Holdings. We initiated a new position in Gamesys. Gamesys is exposed to a structurally growing market (online gaming, mainly bingo and casino games) which has been given a further boost by the Covid-19 pandemic. The company reported exceptionally strong interim results in the period showing rapid deleveraging allowing the board to declare an inaugural dividend. We added to our recently initiated position in Genus (see Q2 update) and used share price weakness to increase our holding in housebuilder Vistry Group. Vistry published reassuring interim results in the period and looking forward we see good potential in the capital light partnerships business, which the market appears to be overlooking. The partnerships business works closely with housing associations and the public sector more generally to deliver affordable housing under long-term development agreements, offering good visibility. Shortages of affordable housing are likely to drive co-operation between the public and private sector aided by ongoing central government support – there are plans for state-backed 95% loan-to-value mortgages to replace support offered to first-time buyers from the Help to Buy scheme, whose winding down may account for some of the recent poor investor sentiment towards Vistry. We took some profits in Pets at Home and Dunelm and disposed of our position in Just Group.
We were not at all surprised by the news the UK economy grew by 6.6% in July. After all, pay fell by just 1.6% in the second quarter of 2020 which was obscured by a narrow focus on a predictably poor GDP number whose calculation methodology has some shortcomings. For example, education accounts for 6% of GDP, so if the schools are closed that goes to zero since the UK statistics place the emphasis on output when measuring the first estimate of GDP. This is despite the teachers still being paid (i.e. income was normal). Confused? Well, you are not alone there.
So what is going on? The headlines reporting Q2 GDP were predictably hysterical, but the fact is that in the second quarter pay fell by just 1.6% and bank deposits surged as people could not spend the money. The end of lockdown has seen this pent-up demand already being realised in the trading statements from a number of the consumer-facing stocks we own, including Games Workshop, William Hill and Dunelm cited above. So it is important to look at the income and expenditure elements of GDP and not just the output element in isolation.
Looking at this full picture continues to drive our investment approach. In the first few months of lockdown, we were asked what types of new trends were emerging and if they would change our investment approach. This led us to examine our core long term growth opportunity stocks, and whether we believed that the opportunities we saw previously would persist in a post coronavirus world. Trends which we observed early on do seem to be bedding in. Certain secular trends such as online retail and more frequent working from home have accelerated and been reflected in the strong trading updates from Pets at Home, Computacenter and Dunelm as well as other of our holdings such as Telecom Plus, Grainger (high quality private rented accommodation) and self storage specialist Safestore.
More generally, it is reassuring to be able to say that we have not made many changes to our list of long term growth opportunities. One demotion is SSP (which we sold in Q2) and we recognise it now may take longer for the market to share our confidence in serviced office company IWG, but otherwise the pre-Covid-19 list is relatively intact.
As we head into the fourth quarter and the end of the Coronavirus Job Retention Scheme (to be replaced with the chancellor’s “Winter Economy Plan”) we do expect unemployment to rise. The evidence so far, however, suggests that it’s the over-65s, the majority of whom do not have mortgages, and who may have new reasons to leave, who are opting out of the workforce. We also expect that companies will continue to face a number of headwinds but that the economy will, broadly speaking, generate a V-shaped recovery in terms of a rebound in GDP.
We said before that economic turmoil was likely to lead to a number of opportunistic stock ideas. To whit, much has been written over the years about the poor state of productivity of UK plc. The one good thing to come out of this pandemic is that it has forced so-called old economy stocks to achieve five years of change in four months. That can only be a good thing in the long term for the profitability of companies and the health of the economy.
In conclusion, with a cautiously optimistic eye on the UK economy, we continue to primarily focus the portfolio as we have always done: seeking out the next mid-cap disruptor, while looking to avoid exposure to the next industry to be disrupted.
|Q4/2015 -Q3/2016||Q4/2016 - Q3/2017||Q4/2017 - Q3/2018||Q4/2018 - Q3/2019||Q4/2019 - Q3/2020|
|Net Asset Value||6.5||21.0||3.5||1.8||-8.2|
|FTSE 250 ex Investment Trust TR||8.6||14.2||4.2||0.2||-15.3|
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