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Lowland has a disappointing year

Lowland has a disappointing year

Lowland Investment Company (LWI) has announced its annual results for the year ended 30 September 2018. The chairman, Robert Robertson, reports that, during the year, LWI saw a combination of modest capital growth and strong revenue growth with an NAV total return of 2.7%. He says that this has been a disappointing year when measured against LWI’s long-term target, the FTSE All-Share Index, which he says returned 5.9%”. Robert’s statement highlights two key factors. First, the UK market dramatically underperformed the rest of the developed world, reflecting uncertainties about Brexit and the stability of the UK government. Secondly, Lowland’s investment style, weighted in favour of stocks perceived to be undervalued, has fared less well than portfolios with a bias towards growth stocks.

Manager’s commentary on market backdrop – disappointing year

It has been a disappointing year for us in terms of capital growth but it was the tenth consecutive year of positive absolute returns due to good dividend returns. The context for capital growth was challenging. Whilst this has now been a nine-year bull market in equities, there has been little enthusiasm for UK equities from investors. Within the UK market, those companies relying largely on the domestic economy for profits have been particularly out of favour. After an initial bounce after the financial crash ten years ago, these companies’ shares have been de-rated. Currently domestic companies are trading at an approximately 20% valuation discount to the broader market.

Some of this de-rating reflects the absence of a large tech exposure in the UK market; more recently, the decline has reflected uncertainties about Brexit and the impact of a possible change in government. This is exciting to contrarian investors like us, and we are looking for opportunities in the general gloom. It is important in this search to realise that the weakness in many of the older-established businesses in the UK is not just the changing relationship with Europe, but also a response to real structural changes in the UK economy. For instance, the move to retailing online has meant many of the older ‘brick and mortar’ retail formats are under severe pressure. This is an area in which Lowland has little exposure.

Online shopping has grown more rapidly in the UK than in other developed countries and the growth is dramatic. These trends are not just dramatically shifting the business model of retailers: the growth of online retail is also behind the large discounts in the property sector. Notwithstanding the perceived background problems, Lowland has benefitted from robust real dividend growth, and as a result Lowland’s earnings per share rose 19.3% (including special dividends). This is because overall cash generation in portfolio companies is strong, and on average continue to trade satisfactorily. Lowland’s approach has always been to hold a diverse, relatively long list of stocks that offer good value. This diversity should help to protect the capital if there is a difficult period for the economy.

Manager’s commentary on performance attribution

In a continuation of a trend we have seen in recent years, high-quality companies with strong management teams and solid earnings growth continued to perform well and valuations rose; yet ‘value’ investing, focusing on cheap valuations rather than growth, did not work as a discipline.

This market bifurcation is reflected in the top five performers listed below, all of which are excellent quality companies with strong management teams; but we struggle to describe them as good value. Therefore, while we describe our investment style as ‘mildly contrarian’, we need to recognise that at the moment, recovery and value investing are  (broadly) not working, while quality is performing well. In this context, where we are reducing holdings, we are doing so in small size and we are being cautious with recovery purchases.

The top five active contributors to performance (relative to the benchmark) that we own were:

1. Hiscox (Non-Life Insurance)
2. K3 Capital (corporate broker for small and medium-sized companies)
3. Randall & Quilter (insurance services)
4. Croda (speciality chemicals)
5. GKN (engineering)

The only common theme among the top performers is that they are all specialists, targeting niche areas of the market with real expertise. Hiscox is a good example of this. Its relatively small size in the Lloyd’s of London market allows it to be nimble and exit lines of business where it does not expect to generate good returns. Another specialist in its area, Randall & Quilter, buys books of business that are in run-off in non-life insurance (often workers’ compensation books). As they build up a history of successfully integrating legacy books, they are increasingly approached by other companies that wish to transfer their liabilities off balance sheet. This then becomes a virtuous circle and allows the business to grow as it attracts more willing sellers.

Another of the top performers was K3 Capital, a specialist corporate brokerage business targeting small and medium-sized companies that are looking for a buyer (which could be a trade buyer or private equity).  By focusing its efforts on smaller companies that have not traditionally been well served by incumbents, it has rapidly built up its market share.

The top five detractors from performance (relative to the benchmark) were:

1. Conviviality (alcohol distribution and retailing)
2. Low & Bonar (building materials)
3. Centrica (UK and US energy supplier)
4. Carclo (plastic moulding and lighting for ‘supercars’)
5. Velocys (early-stage gas to liquids technology)

The largest detractor during the year was Conviviality, an alcohol distributor and owner of the ‘Bargain Booze’ retail franchise. A combination of poor trading and weak internal controls resulted in the company going into liquidation, and it was written down to zero. We discussed this in more detail in our half-year results: it was a sharp reminder that distributors should not be highly valued businesses, given their low margins.

Of the top five detractors, Low & Bonar and Carclo both suffered cost increases which put pressure on margins. In the case of Low & Bonar, which makes specialist building materials such as truck tarpaulins, it was raw material price rises which dented margins, while in Carclo’s case it was labour shortages that led to wage rises. Both companies struggled to pass on cost pressures to the end consumer, demonstrating the commoditised nature of some of the products. However, both companies also have better-quality parts of the business where they produce something unique. For example, in the case of Carclo, their Wipac division makes lighting for ‘supercars’, where they are the market leader. In both cases we have maintained the positions as we see value in these better-quality parts of the business that is not, in our view, reflected in the current share price.

Manager’s commentary on portfolio positioning

The two largest sectors in the portfolio remain financials and industrials. It is worth noting that financials is somewhat of a ‘catch all’ sector, including other investment trusts (such as Herald) and property companies (such as Land Securities). Within financials the largest sector is insurance (15% of the portfolio), while banks have remained a small position (5% in total).

Within the insurance sector we continue to favour specialist underwriters – for example, this year a new position was added in Sabre, a motor insurer that targets a small ‘non-standard’ area of the UK motor market. They target individuals who cannot easily acquire motor insurance (for example students or those with particularly high-value cars). This focused approach has allowed Sabre to generate strong historic returns in what is traditionally a difficult market.

Within the industrials sector we aim to hold good-quality engineers, with the two largest holdings in the sector being engine designer and manufacturer Rolls-Royce and autos and aerospace components manufacturer Senior. These companies have genuine barriers to entry. In the case of Rolls-Royce, it has cost billions of pounds and considerable technological capacity to develop the Trent engine over 20 years. These barriers to entry should allow good margins to be generated over time as the next generation of engines enter high margin service agreements. The inherent value in this type of engineer was demonstrated this year with the takeover of one of the portfolio’s top ten holdings, GKN, at a material premium.

Manager’s commentary on investment activity

Over the long term, the approximate average position would be to have a third of the portfolio in small companies, a third in medium-sized companies and a third in large companies. Currently we have 39% in the FTSE 100, which is above the long-term average, as we have added to the holdings here over the year. This is reflected in the biggest buys below, the majority of which are in the FTSE 100.

The biggest buys over the year were:

1. Severn Trent (water utility, new position)
2. Land Securities (London offices and shopping centre real estate company, new position)
3. Greene King (UK pubs, new position)

Other large purchases included adding to the positions in Royal Dutch Shell, GlaxoSmithKline and National Grid, and a new holding in Anexo (which provides legal services and replacement vehicles for those involved in motor accidents).

There are a few reasons why we have been gently rotating the portfolio towards larger companies. Broadly, these reasons are better liquidity, a shift towards more defensive companies and the attractive dividend yields on offer. In many cases we are also adding to what we see as good quality companies at an attractive valuation versus history. For example Land Securities, which is trading at an approximately 40% discount to its estimated net asset value, has a good quality portfolio of shopping centres and offices and this valuation looks to be an anomaly (likely driven by Brexit) relative to other global property companies.

The biggest sales over the year were:

1. GKN (autos and aerospace components engineer, sold following Melrose takeover approach)
2. Phoenix Group (closed book life insurer, reduced position for portfolio balance reasons)
3. Croda (speciality chemicals, reduced position)

Unless we had structural concerns or there was a takeover approach, sales were broadly driven by valuation levels. For example, the holdings in Hiscox, Croda and Marshalls were reduced. All are good-quality businesses that are generating excellent returns but have re-rated substantially and we think it is prudent to take profits. We will hopefully be able to recycle these profits in better value opportunities on weakness.

Manager’s commentary on outlook

The outlook for the UK economy over the next year is difficult to predict. The economists who put forward estimates of GDP growth have a wide range of outcomes in their respective forecasts. Some predict reasonable growth, while others expect a recession. The result of Brexit negotiations and their implications are unclear, as is the damage a trade war between the US and China will create. However, the most likely outlook is for the global economy to keep on growing, albeit at a slow rate, as some of the issues are resolved. There is a possibility that the changes to trading arrangements brought about by Brexit for the domestic economy, and Trump more generally, may lead to a recession next year. As this is less likely than the first scenario, we remain fully committed to equities, but gearing is lower than its historic average. We have also reduced the smaller company and cyclical elements in the portfolio to provide some protection in the event of a recession.

We will keep paying full attention to smaller companies and cyclicals and on real weakness the exposure will be rebuilt. It is in this area that very good returns will be made when coming out of a slowdown. The core of the portfolio is in sound, growing companies that should increase their dividends. This should help underpin Lowland’s earnings progression. It is dividend growth that makes equity investment worthwhile over the longer term. The portfolio is not a proxy for the economy but rather a balanced collection of companies that we believe are very well managed and will therefore come through any economic turbulence.

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