Lowland couldn’t match index driven by largest stocks

Lowland says that, over the 12 months ended 30 September 2022, its NAV total return was -14.8% and the return to shareholders was -16.4%, which compares with a return of -4.0% for the All-Share over that period. The annual dividend was upped from 6.025p to 6.1p, double the dividend 10 years earlier.

Lowland’s investment policy is designed so that exposure to the 100 largest companies is capped at 50% of the fund in normal circumstances, whereas these now represent about 83% of the All-Share. That structural bias towards smaller and medium sized companies is the main driver of Lowland’s underperformance, as the very largest stocks drove the index’s returns.

The chairman notes that:

• the portfolio trades on an a weighted average of 8.7x historic earnings;
• the revenue of small and medium sized companies is far more weighted to the UK than in the case of larger companies, as demonstrated by the 51% domestic sales exposure for the Lowland portfolio against 23% for the All-Share;
• the UK market as a whole is trading at a significant discount to other developed equity markets (for example, UK equities were trading at a near 40% discount to the MSCI World Index). The UK’s near pariah status has pertained since before Brexit, and has been confirmed by a succession of ‘events’, the most recent being what can fairly be characterised as political chaos;
• the best performers on the UK market have been broadly among the 20 largest companies, often in commodities businesses which have benefitted from the consequences of Putin’s war; and
• in times of nervousness smaller companies are often perceived to be inherently risky and sold off indiscriminately.

The board also monitors Lowland’s performance against that of a composite index, being 50% All-Share/50% Numis Smaller Companies ex Investment Trusts, and the trust outperformed that by 1.6% over the period.

The trust’s performance since 30 September has been better – returning 10.5% in NAV terms and 12.4% in share price terms, against 9.0% for the benchmark.

Extract from the managers’ report

At the stock level the impact of the concentration within the benchmark can be clearly seen, with a number of the largest detractors from relative performance being underweights in areas such as natural resources. Shell, for example, which was the company’s largest holding at year end and the largest contributor to absolute performance, was (despite this) the second largest detractor from relative performance (see second table below) as on average over the year it made up 5.6% of the benchmark compared to only 2.9% for Lowland. This demonstrates the difficulties in managing a multi-cap portfolio relative to a concentrated benchmark. If the circumstances are such (as they were this financial year) that the largest benchmark constituents perform very well, it is challenging for a broader, multi-cap fund to hold weights level with the index. This can act as a material detractor from relative returns.

While the different size allocation of the portfolio in comparison to the benchmark was the key determinant of relative performance this year, we have included below a brief summary of the main contributors and detractors from performance at the stock level.

The top ten contributors to relative returns were:

In examining these best performers there are a number of themes that can be drawn out:

• Rising energy prices – the rise in the price of natural gas and subsequent rise in UK power prices drove earnings upgrades in Serica Energy and Centrica.
• Rising interest rates – global bank Standard Chartered performed well on the expectation that a rising interest rate environment will be positive for future lending margins.
• Returns to shareholders – Insurers FBD and Aviva performed well following material distributions to shareholders. In FBD’s case they returned to paying ordinary dividends following a resolution to their COVID-19 business interruption claims, while Aviva returned one-off proceeds from business sales.
• Takeover activity – Euromoney Institutional Investor received a takeover approach from private equity. This has been a recurring theme in recent years given the valuation discount on the UK equity market relative to overseas.

The largest ten detractors from relative return were:

Examining each of these largest detractors:

• Studio Retail was written down to zero in very disappointing circumstances. We discussed the reasons within the half year report, however to summarise, the company incurred supply chain disruption, which led to a working capital outflow and the company reaching the limits of its lending facilities.
• Shell and Glencore saw substantial earnings upgrades as a result of higher commodity prices.
• British American Tobacco and AstraZeneca rose due to their defensive qualities at a time of market uncertainty.
• Reach (formerly Trinity Mirror) fell materially from its highs due to rising costs of print as well as pressure on digital advertising yields following the Russia/Ukraine war.
• Ilika fell following lower than expected demand from industrial customers for its next generation battery technology. There was also a broader de-rating in the market of early stage, loss making businesses, which led to the share price fall in IP Group (which saw the share price of its key portfolio holding, Oxford Nanopore, fall substantially).
• Headlam Group (a flooring distributor) fell due to concerns that pressure on household real disposable income would impact people’s willingness and ability to spend on new flooring.
• Morgan Advanced Materials (a specialist materials company serving end markets such as industrial, healthcare and semiconductors) fell due to concerns surrounding a slowdown in the global economy.

LWI : Lowland couldn’t match index driven by largest stocks